What impact will the rating upgrade have on the company’s liquidity ratios and capital adequacy ratios?
Short answer:
The KB‑R‑A (KBRA) upgrade of The Bancorp’s credit ratings (senior unsecured debt → BBB+, subordinated debt → BBB, short‑term debt → K2) signals that the rating agency now views the company’s ability to meet its financial obligations as stronger than before. The upgrade itself does not directly change the numbers in the bank’s liquidity‑ratio or capital‑adequacy‑ratio calculations, but it is both a reflection of recent improvements and a catalyst that can enhance those ratios in the near‑term through:
- Lower funding costs (cheaper debt, easier access to capital).
- Higher investor confidence → higher deposits and potentially larger equity capital.
- Regulatory and market perception that the bank is a lower‑risk institution.
Below is a comprehensive, step‑by‑step explanation of how the rating upgrade can influence the Bancorp’s liquidity and capital adequacy ratios, the mechanisms that drive the changes, and the caveats that must be kept in mind.
1. Why a rating upgrade matters for liquidity & capital ratios
| Rating Upgrade | What it Signals | How it Impacts Liquidity & Capital |
|---|---|---|
| Senior unsecured debt: BBB → BBB+ | Stronger ability to meet long‑term obligations; lower perceived default risk. | • Lower interest expense → higher retained earnings → higher Tier‑1 capital (via retained earnings). • Lower cost of issuing new senior debt → less cash outflow for interest, preserving cash and increasing cash‑to‑deposits and cash‑to‑assets ratios. |
| Subordinated debt: BBB‑ → BBB | Improved capacity to service more junior obligations; a sign of deeper capital cushions. | • Subordinated debt is part of Tier‑2 capital. Upgrading it improves the “risk‑adjusted” view of the bank’s capital base, making the Tier‑2/Total Capital ratio look stronger. |
| Short‑term debt: K2 → (implied) K1 (the article truncates, but the upgrade to K2 indicates a strong short‑term rating) | Confidence in ability to meet near‑term obligations. | • Lower short‑term borrowing costs → higher cash on hand → higher Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR). |
| Overall rating improvement | Overall risk profile is now “investment‑grade” rather than “speculative” (BBB+ is the first tier of the “investment grade” band). | • Credit‑rating‑driven “credit‑spread compression” → cheaper borrowing → higher liquidity buffers and capital ratios. |
2. Direct Effect on Liquidity Ratios
Liquidity ratios most analysts monitor for a U.S. bank are:
| Ratio | Formula | How the rating upgrade can improve it |
|---|---|---|
| Liquidity Coverage Ratio (LCR) | High‑Quality Liquid Assets (HQLA) / Net cash outflows over 30 days | • Lower funding costs → more earnings retained → more HQLA (e.g., cash, Treasury securities). • Lower “cash‑outflow” assumptions (e.g., less need to sell assets at discount because of stronger market perception). |
| Net Stable Funding Ratio (NSFR) | Available stable funding / Required stable funding | • Ability to raise longer‑term funding at cheaper rates → increase the denominator (stable funding). • Reduced reliance on short‑term wholesale funding → higher NSFR. |
| Cash‑to‑Deposits Ratio | Cash & cash equivalents / Total deposits | • Lower cost of deposits (through better rates offered to customers) reduces “cost of deposits” → retains more cash. • Higher deposit inflows (customers perceive bank as safer) increase “cash” component and improve the ratio. |
| Loan‑to‑Deposit Ratio (LDR) | Total Loans / Total Deposits | The rating upgrade does not directly change the numerator, but the improved funding cost encourages more loan growth without a proportional rise in deposits, potentially raising the LDR. However, banks typically manage LDR to stay within regulatory limits, so the impact is often neutral or modestly positive. |
| Cash‑Coverage Ratio (CCR) (Cash / Total Debt) | Cash / Total Debt | Lower cost of debt → slower increase in total debt → higher ratio. |
Key Take‑away: The primary driver is cheaper, longer‑term funding and higher retained earnings, which raise the numerator (cash / HQLA) while keeping the denominator (cash‑outflows or funding needs) modest. Hence, LCR, NSFR, and cash‑coverage ratios will improve relative to the pre‑upgrade level.
3. Direct Effect on Capital Adequacy Ratios
Bank regulators track:
- Common Equity Tier‑1 (CET1) Ratio = CET1 Capital / Risk‑Weighted Assets (RWAs)
- Tier‑1 Capital Ratio = Tier‑1 Capital / RWAs
- Total Capital Ratio = (Tier‑1 + Tier‑2) / RWAs
- Leverage Ratio = Tier‑1 Capital / Average Total Consolidated Assets
How the upgrade can help each:
| Ratio | Impact Pathway |
|---|---|
| CET1 Ratio | • Higher retained earnings (from lower interest expense) increase CET1 capital. • Lower risk‑weighted assets (RWAs) may be re‑weighted down if the bank’s risk profile improves (e.g., more high‑quality assets, lower loan‑loss provisions). |
| Tier‑1 Ratio | Same as CET1, plus any new Tier‑1 instruments (e.g., preferred shares) that could be issued more cheaply because investors see lower risk. |
| Total Capital Ratio (Tier‑2) | The upgraded subordinated debt rating (BBB) signals that the bank’s Tier‑2 instruments are more credible, thus the regulatory add‑on (e.g., a “subordinated debt discount” that regulators sometimes apply) will be lower, improving the effective Tier‑2 component. |
| Leverage Ratio | If the bank uses the cheaper debt to grow assets (e.g., new loans) without a proportional increase in Tier‑1, the leverage ratio can decrease (i.e., become worse). However, the overall risk‑adjusted capital still improves because the bank now has more “quality” capital. |
| Liquidity‑adjusted Capital (often used in stress‑testing) | Better LCR/NSFR results reduce the need for capital buffers for liquidity‑stress scenarios, effectively freeing up capital that can be counted toward CET1. |
Bottom‑line: The upgrade generally lifts the CET1, Tier‑1, and Total Capital ratios because it reduces the amount of extra capital the bank needs to hold as a safety cushion. The leverage ratio may experience a modest downward pressure if the bank expands assets faster than capital, but this can be managed through controlled asset growth.
4. Quantitative “What‑If” Illustration
Below is a hypothetical illustration (the numbers are illustrative only; actual figures are not disclosed in the news) showing how a rating upgrade could translate into measurable changes in ratios.
| Metric (Pre‑Upgrade) | Metric (Post‑Upgrade, after 1‑yr) | % Change |
|---|---|---|
| Interest expense / total assets | 3.2 % → 2.8 % | –12 % (cost of debt falls) |
| CET1 Capital (as $bn) | $0.75 → $0.82 | +9 % (retained earnings) |
| Risk‑Weighted Assets | $6.0 → $5.8 | –3 % (improved asset mix) |
| CET1 Ratio | 12.5 % → 14.1 % | +1.6‑points |
| Total Capital Ratio | 13.5 % → 15.0 % | +1.5‑points |
| LCR | 115 % → 124 % | +9 % |
| NSFR | 105 % → 112 % | +7 % |
| Cash‑to‑Deposit | 15 % → 18 % | +3 % |
These illustrative numbers show how lower borrowing costs translate into higher capital and stronger liquidity—the exact magnitude will depend on the actual debt structure, deposit growth, and risk‑weighting methodology.
5. Why the Upgrade Happened (and what it tells us)
Although the press release does not detail the underlying metrics, rating agencies typically upgrade a bank when it:
- Reduces its non‑performing loan (NPL) ratio – signaling higher asset quality and lower risk‑weighted assets.
- Improves its net interest margin (NIM) or profitability – providing more earnings to retain.
- Strengthens its funding profile – e.g., more stable retail deposits, lower reliance on wholesale funding.
- Increases its capital base through profit retention, capital raise, or lower risk‑weighting.
If any of these occurred, the ratios themselves already improved before the rating upgrade, and the upgrade merely recognizes the improvement. In other words: the upgrade is the result of stronger ratios, not the cause. However, future ratio behavior will be positively impacted because the upgrade improves the cost environment and the market perception that drives future performance.
6. Potential Risks / Caveats
| Risk | Explanation |
|---|---|
| Debt‑Driven Growth | If the bank aggressively expands its loan book using the new cheap debt, the risk‑weighted assets may rise faster than capital, potentially eroding the CET1 ratio. |
| Liquidity‑Funding Mismatch | A higher LCR does not guarantee sustained liquidity if the bank’s deposit base shrinks (e.g., higher interest rates elsewhere) or if wholesale funding conditions deteriorate. |
| Regulatory Re‑Assessment | Rating agencies may revise the upgrade if market conditions change (e.g., a recession). The bank should not rely solely on the rating for its capital plan. |
| Market Perception vs. Fundamentals | A rating upgrade may raise expectations (e.g., higher dividend payouts). If those expectations are not matched by underlying earnings, the CET1 ratio could later deteriorate. |
| No Immediate Ratio Change | The rating upgrade does not automatically adjust any ratio. The bank must actually generate higher earnings or reduce risk‑weights to realize the improvements. |
7. Bottom‑Line Summary for Decision‑Makers
Liquidity Ratios: The upgrade should improve LCR, NSFR, cash‑to‑deposit, and cash‑coverage ratios by reducing funding costs, raising cash balances, and lowering the need for emergency liquidity.
Capital Adequacy Ratios: The upgrade is expected to raise the CET1, Tier‑1 and Total Capital ratios (via higher retained earnings and a lower risk‑weighting profile).
Leverage Ratio: May experience downward pressure if asset growth outpaces capital; this can be mitigated by disciplined growth and additional capital raises if necessary.
Overall Impact: The qualitative signal—the bank is now seen as a lower‑risk institution—will translate into quantitative improvements as the firm leverages cheaper funding and higher confidence to strengthen its balance sheet.
Action Items:
- Monitor actual changes in interest expense, deposit composition, and retained earnings over the next 12‑18 months.
- Model the effect of a 50‑100 basis‑point reduction in cost of funding on the cash‑flow statement to gauge the incremental increase in cash and the CET1 boost.
- Re‑assess loan‑to‑deposit and LCR thresholds quarterly to ensure the liquidity improvement is sustained.
- Monitor actual changes in interest expense, deposit composition, and retained earnings over the next 12‑18 months.
By tracking these metrics, The Bancorp can confirm that the rating upgrade translates into tangible improvements in its liquidity and capital adequacy, not merely a change in a rating letter. This will further strengthen its standing with regulators, investors, and counterparties.