Bank credit rating dynamics

An increase in the credit rating on an organisation’s debt is generally perceived positively, as higher credit ratings are, in the main, associated with lower perceived volatility in the market value of the assets of the entity that has issued the debt. If banks price their assets to realise a target return on economic capital, then a higher credit rating will result in higher loan rates if the fall in the bank’s cost of capital, associated with the lower insolvency risk, is insufficient to offset the required additional net income on the loan. In this paper we develop a loan pricing model that assumes that banks price their assets on a risk- and cost-adjusted basis and with the aim of achieving a minimum required return on the bank’s economic capital holding. We compare theoretically derived decreases in the bank’s cost of funds to actual bank credit spread data from the European and the US markets in order to ascertain the extent to which the increase in credit rating is beneficial to the bank. We find that the minimum decline in the cost of funds in our model generally exceeds the empirical data, meaning that the reduction in funding costs is insufficient to offset the increase on loan rates associated with higher economic capital. The divergence increases as the proportion of retail funds increases. We further find that the hurdle rate on economic capital is a significant factor in determining the value of a bank increasing its solvency standard.