The ability of rating agencies to be forward-looking and "accurate" relative to various market pricing mechanisms is an ongoing topic in the capital markets. While such comparisons can provide useful observations, they sometimes lead to misguided conclusions. To fully appreciate why this is important for banks, it is worth briefly reviewing what credit ratings do and do not reflect.

Ratings attempt to express a view based on a multitude of complicated qualitative and quantitative factors. Their purpose remains to provide a useful benchmark of the relative ability of an entity or transaction to meet their contractual obligations in a timely manner.

Market indicators can certainly be helpful, but often they are influenced by factors away from credit-factors which by design ratings do not try to replicate. Ratings focus on fundamental credit factors. However, as we are witnessing, sustained stress in key variables such as funding and liquidity can take on greater or different significance among the factors considered.

One point is often lost in the narrative about ratings through the crisis: across most sectors ratings have performed as expected, with the obvious exception being structured finance tied to the U.S. housing market and collateralized debt obligations.

Credit ratings incorporate historical data and experiences but also consider how the future may deviate from past results. In the higher categories, ratings typically have tolerances built in to them so that cyclical change, temporary weakness, or other expected factors do not lead to unexpected or outsized rating activity. Fitch's ratings are increasingly supported by research that speaks to types of stress and relative sensitivities of key assumptions or events.

Bank ratings, particularly those in the euro zone and the large global trading and universal banks, have seen increased ratings activity over the last 12 months. New regulations and supervisory expectations are being implemented to improve the soundness of the global banking system and to limit the need and/or the ability of governments to provide future support. Fitch's rating actions thus far seek to incorporate these key interrelated variables and how these changes could influence future creditworthiness.

The Global Trading and Universal Banks, or GTUBs, are 13 global banks which Fitch identifies as unique due to their size (largest), business scope (heavily involved in the securities business), complexity, and less transparent business models. Fitch believes these banks are particularly vulnerable to market sentiment and confidence, especially during times of stress. Their funding structure makes them more reliant on market access and price, their earnings are more volatile due to their dependence on market volumes, and they have large notional on- and off-balance- sheet risks that can change quickly. As a result, Fitch primarily concluded the GTUBs' profiles were consistent with the "A" category, which is lower than their historical ratings but consistent with the downward rating migration in the rest of the sector.

Various market pricing mechanisms tell a different story, however, with certain banks in this group experiencing outsized volatility and wider spreads in the credit derivatives market. Whether the ratings perform as expected-or even outperform relative to the depth and duration of stress encountered-is something we will know only with the fullness of time.

Better-performing institutions will continue strengthening their financial profiles and adjusting their business mix to fit the economic realities of new capital requirements and revised regulatory expectations. In the face of those changes, Fitch's ratings will continue to reflect our relative view of the risks and how new measures being contemplated, or enacted, will interact with them.


John Olert is global chief credit officer at Fitch Ratings.

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