Relationship between individual features of the major European banks and their ratings

Abstract

Following the 2007 subprime crisis, interest rates dropped dramatically, making savings accounts look unattractive. This is why investors should consider acquiring risky assets if they expect moderate or high returns. The creditworthiness of risky assets should be examined wisely, in order to make sure risk are taken consciously. Due to the increasing complexity of financial instruments we observed in the last two decades, assessing a firm's creditworthiness with a large scope has become very difficult. For these reasons the relevance of credit rating agencies (CRAs) increased. Credit rating agencies assign an easy to interpret credit ratings to firms after having evaluated its creditworthiness. Credit ratings are displayed in the form of a letter grade. The letter A is assigned to the most creditworthy firms, while C is assigned to the least creditworthy firms. This thesis presents the history of the CRA market, the importance of CRAs, what is known about the rating methodologies and why they started to be criticized in the recent years. One of the reasons presented is that CRAs use intransparent methodologies in order to compute credit ratings. Moody's Investors Service (2016) states that in order to compute a bank's credit rating, macro-economic features, individual financial characteristics and qualitative information are analyzed. In this paper, several financial and accounting characteristics of major European banks are analyzed in the empirical study. In order to make the computations, a sample composed of 32 of the 61 biggest European banks is used. Computations have been conducted in order to identify the influence of banks' financial characteristics on the credit ratings emitted by Moody's and Standard and Poor's (S&P), the two biggest CRAs. The main results of the empirical research showed that non-performing loans and the return on equity had the biggest influence on the ratings emitted by Moody's and S&P. As the non-performing loans lowers the rating assigned to the banks, the return on equity has a positive impact on the credit ratings. In addition, computations indicated that by analyzing the non-performing loans and the tier 1 capital of a bank, Moody's and S&P's rating decision can be explained at 60%. This amount is decreasing, which may imply an increase in the importance of qualitative data in the rating decisions.