The Big Three Are Downgrading Banks, But Are They In Bad Shape?

Ann Rutledge
August 28, 2023

On August 7, Moody’s Investors Service (MCO) kickstarted a cascade of bank rating actions, downgrading 10 banks or bank holding companies (BHCs), placing six more under review and putting negative outlooks on another 11.

On August 15, Fitch Ratings, smallest of the Big Three NRSROs, told the market it wasn’t kidding when it lowered the U.S. banking industry’s operating environment score in late June and subsequently downgraded the U.S. long-term sovereign rating August 1. If rate hikes continued, Fitch cautioned that it might “be forced to” review over 70 banks and downgrade dozens. Shares in JPMorgan, Bank of America BAC +0.4% and Citigroup C+0.6% fell after the Fitch announcement. On August 21, one week later, S&P (SPGI) downgraded five mid-sized banks. Bank share prices dropped again.


The credit story here is obvious. Banks make money on the spread between their loan products and their cost of funds. The Fed has been aggressively raising funding costs: from 0.08% at the pandemic peak, in 2021, to 2.33% in August 2022, to 5.33% now, and it will go on rising if inflation persists. Just as Americans are having to pay more for goods, services and loans, so too are U.S. banks having to manage through lower demand, shrinking margins, evaporating liquidity, decreasing capital quality and real estate asset devaluations. Under the circumstances, bank downgrades would seem natural or inevitable.

But in an August 21 editorial, the American Bankers Association, the U.S. bank lobby, claimed the rating agencies missed the mark. My firm, Credit Spectrum Corp., arrived at a similar conclusion completely independently, after scrutinizing our proprietary bank health index, which we update quarterly using data on bank capital, liquidity, asset quality and earnings as reported to the Federal Financial Institutions Examination Council(FFIEC).

By comparing index readings taken at Q1 2021 (before rates rose) to those at Q1 2023 (post-meltdown) we found 80% of the downgraded banks are actually stronger credits now than in 2021. Among Moody’s 10 downgrades, only Amarillo National Bank’s score did not improve. Old National Bancorp (ONB) of Evansville, IN ($48.2BN in assets) and Pinnacle Financial Partners (PNFP) of Nashville, TN ($46.7BN) improved 48% and 28%, respectively. Three banks downgraded by S&P improved by an average margin of 14%, but only one, UMB Financial (UMBF) of Kansas City, MO ($208 BN), outperformed its cohort ($50 - $250BN in assets).

Undoubtedly some U.S. banks are struggling now, but they are not necessarily the ones recently downgraded. That is distinctly odd. What is also odd is that Moody’s and S&P only downgraded 15 of 5000 banks, and only one, Associated Banc-Corp (ASB) was on both of their lists.

It’s a fiction that NRSROs exist purely to deliver neutral, objective credit information to the market. Like any American media company, licensed credit rating agencies have long enjoyed First Amendment protection. But, they are unlike any other media company. NRSRO revenues come mainly from transaction fees, not subscriptions or advertising. Their real economic function is to produce benchmarks for pricing and repricing debt capital. Commercially, they fulfill many (but not all) of the functions of exchanges. They also compete against each other much in the manner of exchanges. At the same time, financial regulators may see their primary function as filling a quasi-regulatory role for financial markets. These insights may shed light on some hidden drivers of rating actions.

Some rated markets (like sovereigns and banks) are deeply intertwined. When the economy is volatile, the correlations complicate an NRSRO’s job. It may resist making a downgrade that is technically warranted by their rating method if the harm outweighs the benefit. Quite possibly, Moody’s Aaa rating on the U.S. constrains its freedom of rating actions on U.S. banks (or vice versa) in ways that are not obvious to the public.


The opposite logic can also apply. NRSROs are oligopolists whose credit information products are designed to capture market share or exploit their dominance in niches. Financial institution (FI) ratings are dominated by the Big Three. Since 2019, S&P, the largest NRSRO, has had the largest market share for FI ratings: 37-38%. That is 5x bigger than fourth-largest, DBRS Morningstar’s share. Whereas, second- and third- largest, Moody’s and Fitch, have been tied at around 23% for years.

Recently Moody’s edged ahead of Fitch, which may explain why the latter threatened to downgrade more than 70 banks (without actually downgrading any) and specifically called out JPMorgan, whose CEO had termed the Fitch sovereign downgrade ’ridiculous’ without naming Bank of America (BAC), Citi (C) or Wells Fargo (WFC).

Finally, NRSRO downgrades may be useful to certain regulatory interests seeking to accelerate the rate of bank consolidation. As Senator Elizabeth Warren recently pointed out in a speech to the U.S. Senate Banking, Housing, and Urban Affairs Committee’s Subcommittee on Economic Policy, U.S. banks shrank from 18,000 to just 5,000 since 1990—a compound average disappearance rate of 1.7% a year over 33 years. She has urged regulators to halt the rubber-stamping of large bank acquisitions of small banks based on communitarian arguments for small banks and against scale.

What appears missing in these discussions is the availability of objective, comprehensive, unbiased analysis of how banks of all sizes are actually performing.