New Fed ratings to score bank groups' risk systems
Federal Reserve's revamped internal rating system now includes risk management factors. Rating rises and falls may follow
From the beginning of this year the supervisory rating system that the US Federal Reserve uses to quantify the relative health of bank holding companies (BHCs) is incorporating a risk management yardstick as the lead component. In future, the internal controls, policies and procedures that a BHC has in place to manage its risks, together with its monitoring and reporting systems, and effective board and senior management oversight will be given numeric values by Fed examiners.
This results from a revamp of the Fed's internal ratings framework, which provides the summary evaluation of a BHCs' condition, for use by the supervisory community at large. The 5,500 bank holding companies in the US are all supervised by the Fed, along with around 640 financial holding companies (FHCs), a more recent designation to which the internal ratings system also applies. (FHCs combine a variety of financial entities, such as insurers and securities firms, as well as banks, within the group structure).
The Fed's internal rating system will now include the risk management component along side other components, such as various measures of the BHC's financial condition, to provide a composite rating. The composite, component and sub-components grades are all based on a numeric scale, from 1 (the highest rating) to 5 (the lowest rating).
Ratings assigned by examiners are communicated to the boards of directors at BHCs and FHCs on a strictly confidential base. Companies are forbidden from telling shareholders or using the rating for any commercial advantage (assuming the rating is strong enough to be an incentive).
Consequences
However, changes in the rating can have consequences. "Well managed" BHCs, defined as having a "satisfactory" rating, enjoy certain privileges under various Fed regulations. The rating may also determine the frequency of supervisory inspections, or - if they are deteriorating - trigger supervisory actions, such as requiring management to undertake a capital plan or withdraw from a particular type of business.
In a December letter to senior supervisors at the Federal Reserve's twelve regional Reserve Banks and BHC managements, Richard Spillenkothen, Fed director for banking supervision and regulation, noted that the ratings of some companies could increase or decrease as a result of incorporation of risk management factors into the rating system. Examiners were told that, during the first inspection cycle under the revised rating system, they should be prepared to discuss the new ratings with senior BHC management, and explain how they compare with the grades received by that institution under the previous rating system. An appeals process remains in place.
Better alignment
Changes in the Fed's internal ratings framework are aimed at aligning ratings more closely with its actual supervisory practices. The increased complexity of the US banking industry has led to a shift over time in the focus of the Federal Reserve's supervisory practices for BHCs away from historical analyses of financial condition toward more forward-looking assessments of risk management and financial factors.
In fact, the Fed did introduce risk management ratings for bank holding companies in the mid-1990s. However, they have not formed the central focus of the rating system. Moreover, as the banking industry has continued to evolve during the last decade, the focus of the Federal Reserve's examination programme for bank holding companies has increasingly centred on a comprehensive review of financial risk and adequacy of risk management, the Fed said in an action notice in December, spelling out its intensions.
By incorporating a risk management scale into the main ratings framework and establishing numeric benchmarks for BHC and FHC senior managements, the Fed is now underlining the importance it attaches to this matter. In general, the Fed says the risk management components and sub components of the ratings system should be viewed as the "forward-looking" constituent, while the financial condition component and sub components should be viewed as the "current" constituent.
On a scale of 1 to 5
Ratings of 1 to 5 are assigned to each of the components and sub-components, as well as the overall composite factor. This scale translates into "strong;" "satisfactory;" "fair;" "marginal;" and "unsatisfactory." Where the overall composite rating is concerned, a designation of "strong" (rating 1) means that the BHC is sound in almost every respect, while "satisfactory" (rating 2) indicates that the group is fundamentally sound, but may have modest weaknesses in risk management practices or financial condition.
A BHC assigned a rating 3 or "fair" grade, exhibits a combination of weaknesses in risk management and financial condition that range from fair to moderately severe. Bank holding companies that are assigned a rating 4 or "marginal" grade have an "immoderate volume of risk management and financial weaknesses, which may pose a heightened risk of significant negative impact" on the deposit-taking subsidiaries.
When a rating is bad
In the case of BHCs rated 5 or "unsatisfactory," the situation is viewed as extremely serious. "The critical volume and character of the risk management and financial weaknesses of BHCs in this category, and the concerns about the negative impact [on deposit-taking subsidiaries of the other entities in the group] could lead to insolvency without urgent aid from shareholders or other sources," according to the Fed formula. Immediate corrective action is required along with constant supervisory attention.
So concerned is the Fed to ensure that its rating system is not exploited that officials will not say how many bank holding companies or financial holding companies are in each rating band, or in which band the majority of these groups are to be found.
However, if a BHC is defined as "well managed" it qualifies for various regulatory privileges such as the speedy processing of applications to undertake certain transactions, and greater discretion when investing abroad. And to be deemed "well managed" it must be graded at least "satisfactory" - ratings 1 and 2 - on both the composite and risk management scales. This might, perhaps, provide a bit of a clue about a BHC's relative standing.
How the rating system works
The new ratings system is known as RFI/C(D), which refers to the components (Risk management, Financial condition, Impact, Composite and Deposit-taking subsidiary). It replaces BOPEC (Bank subsidiaries, Other subsidiaries, Parent company, Earnings and Capital), established in 1979.
The risk management component has four sub-components: Board and Senior Management Oversight; Policies, Procedures and Limits; Risk Monitoring and Management Information Systems; and Internal Controls.
Similarly, the financial condition component also has four sub-components: Capital quality of the banking organisation; Asset Quality; Earnings; and Liquidity.
Each of the components and sub-components is graded on a scale of 1 to 5, as is the "impact" component, which refers to the potential threat that problems at a BHC's non-deposit subsidiary, such as a broker-dealer, could pose to the safety and soundness of another subsidiary that takes deposits from the public. Holding companies are expected by the Fed to be a source of strength for their deposit taking subsidiaries. The impact component is aimed at assessing the risk that such subsidiaries might be negatively affected by the parent company of a financial group or its non-deposit arms.
A resulting composite rating is not, however, necessarily a numerical average of all the components and sub-components. Examiners may give different weights to different components and sub-components, depending on the circumstances. Even so, the composite rating will be expected to bear a close relationship with the ratings assigned to components.
The (D) component rating is derived separately, and relates to the assessment of the individual deposit-taking subsidiaries by other supervisors, from state and federal regulatory agencies. A separate, parallel rating scale is used for this purpose.
Although this (D) component is not directly part of the Fed's composite rating, the risk management and financial condition considerations at the deposit-taking subsidiaries - of which, there may be several - are incorporated into the component grades and are thus indirectly factored in the final composite rating.
