Asset Quality Rating

What Is an Asset Quality Rating?

An asset quality rating refers to the assessment of credit risk associated with a particular asset, such as a bond or stock portfolio. The level of efficiency in which an investment manager controls and monitors credit risk heavily influences the rating bestowed.

Because asset quality is an important determinant of risk that profoundly impacts liquidity and costs, analysts go to great lengths to make sure they issue the most accurate evaluations possible. Indeed, their pronouncements can greatly affect the overall condition of a business, bank, or portfolio for years to come.

Understanding Asset Quality Ratings

Analysts consider a multitude of factors when issuing asset quality ratings, including portfolio diversification, operational efficiency, and how existing regulatory frameworks may or may not limit credit risk.

A rating of “one” may signal that an asset possesses high quality with little credit risk. Such a rating would likely be assigned to ultra-secure U.S. government Treasury bills (T-Bills). At the other end of the spectrum, a rating of “five” would likely be given to assets with significant credit deficits, such as high-risk corporate-issued junk bonds.

Asset Quality and Bank Financial Stability

Asset quality is also 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 comprise a majority of a bank's assets and carry the greatest amount of risk to their capital. Securities may also comprise a large portion of the assets and also contain significant risks. Other items which can impact asset quality are other real estate, other assets, off-balance sheet items, and to a lesser extent, 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 follows: