How credit ratings are playing a key role in the unfolding banking crisis

• The credit ratings of US banks have come under the spotlight recently amid the banking crisis.
• SVB tried to avoid a ratings downgrade by selling bonds, but that backfired and caused a bank run.

Right under the big, bold headlines of the banking crisis, there's usually mention of banks' credit ratings.

On Monday, for example, Moody's downgraded its outlook for the entire US banking sector while placing the ratings of six of the country's banks — including First Republic and Western Alliance — under review for a downgrade.

As panic shoots across the banking sector, US banks' credit ratings have come under the spotlight, and investors are zooming in on how these institutions are graded.

First things first, who are these ratings agencies?

Moody's, S&P Global, and Fitch are three big credit ratings agencies that control about 95% of the credit ratings in the financial markets. They assess the creditworthiness of a company or a country's sovereign bonds, so a downgrade — or, a negative read of the creditworthiness — is significant.

Each of the big three agencies expresses credit ratings on a different scale, but they are generally in the form of letters in the alphabet. They go from AAA to D at S&P Global and Fitch, to AAA to C at Moody's.

This is not a new concept. In fact, during the global financial crisis, credit ratings agencies had been blasted for giving better ratings to risky mortgage-backed securities and collateralized loans.

But they are still widely followed by investors.

"Ratings are not perfect," Eugene Grinberg, the CEO of SOLVE, a market data provider for fixed-income securities, told Insider. "But they do still matter since they allow for an apples-to-apples comparison between two issuers."

This is because the financials of companies are complex and investors can't get a fuller picture from these alone.

"Rating agencies track issuers for many years and are able to identify changes in company performance that may not be evident from their financial statements alone," Grinberg added.

What are credit ratings and why do they matter for banks?

Companies raise funds for expansion or new ventures via fundraising. To raise funds, they can either issue equity — i.e. a stake in the company — or issue debt. One way to issue debt is through bonds — an instrument which is repayable after a set period and one that accrues interest in pre-set installments.

If a company face troubles, investors could stop receiving interest payments and risk their principal investments in the bonds — constituting a default. Credit ratings agencies provide independent assessments of the risk that this could happen.

Depending on the rating, a bond can be classified as an investment-grade or speculative-grade investment. A so-called junk bond falls below the investment-grade credit rating at various credit agencies.

Credit ratings agencies have their own methodology when determining creditworthiness — which explains why not all agencies may downgrade a company's debt at the same time. Similarly, a company will generally have to demonstrate that it has a lower risk of default to get an upgrade.

"Rating agencies have a few thresholds in terms of financial ratios that an issuer needs to pass to get an upgrade. Each ratio is not just historical but projected in the next one year ahead," Warut Promboon, managing partner at Hong Kong-based research firm Bondcritic, told Insider. So, the company management needs a plan to convince rating agencies they will be able to pass the thresholds within a year to get an upgrade, he added.

Many metrics — such as management and corporate governance — are also qualitative, "so it is also about management looking good in the agency's eyes," he added.

What happened with SVB's botched capital call?

A downgrade to junk status by a credit ratings agency is serious business as it is not just reputational damage for companies that could impact investor confidence, but — just like how personal credit scores work — it also means companies have to pay out a higher interest rate to investors because they are now deemed to be riskier.

It is exactly the threat of downgrade that contributed to Silicon Valley Bank's demise, Reuters reported on March 11, citing two people familiar with the situation.

Silicon Valley Bank had parked much of its customers' deposits into bonds because its tech-focused customers didn't need a lot of loans during the tech boom during the pandemic. But as the industry started to draw down on deposits amid a slowdown in the sector, Silicon Valley Bank found itself in a position where it had to sell some assets to meet customers' withdrawal requests.

Moody's communicated to the bank that it was preparing to downgrade its rating as the value of its bonds was falling due to rising interest rates, per Reuters.

To avoid the downgrade, Silicon Valley Bank sold a bond portfolio. However, the bonds it could readily sell have lost value due to the Federal Reserve's aggressive rate hikes over the past year — because the value of the bonds moves inversely to interest rates.

The bank then disclosed it was facing a $1.8 billion loss on the sale and then tried to recoup the losses by trying to sell stock and issuing related securities that would generate higher returns.

But these actions triggered concerns among tech VCs and founders about Silicon Valley Bank's financial stability, spurring an old-fashioned bank run and sparking fears of contagion in the banking sector, particularly in smaller, regional banks.

Silicon Valley Bank was shut down by regulators on Friday, but not before spooked depositors also made a run on deposits at crypto-friendly Signature Bank, New York, which faced a similar fate on Sunday.

Consumers are now moving their deposits from smaller to larger banks, such as Bank of America, Citigroup, and JPMorgan Chase, the Financial Times reported, citing sources familiar with the matter.

First Republic has been downgraded to junk. Now what?

Fears of the crisis spreading have also hit the credit ratings of First Republic Bank.

Ratings agencies S&P Global and Fitch cut First Republic's credit rating to junk status on Wednesday over concerns that depositors could pull funds from the lender.

"We believe the risk of deposit outflows is elevated at First Republic Bank despite the actions of federal banking regulators and the bank actively increasing its borrowing availability to mitigate risk associated with the bank failures over the last week," wrote S&P Global Ratings analysts Nicholas Wetzel and Rian Pressman.

First Republic Bank is now considering various options —including a sale – Bloomberg reported Wednesday, citing people with knowledge of the matter. The San Francisco-based lender is also looking at options to boost liquidity, per the news outlet.