One of the most important competitive advantages a bank can have is a high credit rating, which enables it to borrow money at lower interest rates than its peers with worse ratings can. This is a powerful advantage, because a lower cost of funds increases a bank's profitability without simultaneously increasing risk.

Banks aren't just randomly assigned a credit rating; the ratings are instead the end result of an extensive analysis into the likelihood that a bank will someday default on debts to bondholders or other creditors.

A magnifying glass on a table.

Image source: Getty Images.

Moody's (NYSE:MCO), which is one of three main ratings agencies along with Fitch and Standard & Poor's, breaks the analysis down into multiple stages, the most important of which is a bank's baseline credit assessment, or BCA.

A bank's BCA is a function of three things:

  • A macro profile, which captures the bank's operating and economic environment.
  • A financial profile, which captures the bank's financial health.
  • And qualitative adjustments, which reflect non-financial qualitative judgments.

Breaking this down further, a bank's macro profile consists of an assessment of the systemwide factors that Moody's believes are predictive of the propensity of banks to fail. This profile includes economic variables such as:

  • GDP growth.
  • interest rates.
  • asset prices.
  • global capital flows.

The financial profile, by contrast, focuses on a bank's solvency and liquidity.

  • Solvency is defined as a combination of asset risk, leverage, and earnings -- the weaker and less predictable the asset quality, the higher the required capital and/or returns.
  • Liquidity is determined by a bank's funding profile together with its ability to access cash -- the less reliable the bank's sources of funds, the larger the buffer of liquid assets required.

You can see how Moody's weighs these factors in its schematic of a bank's financial profile:

A schematic showing how Moody's assesses a bank's financial profile.

Image source: Moody's.

And the final stage consists of three additional factors that, according to Moody's, are "important qualitative contributors to the soundness of a financial institution but which are either: (1) nonfinancial in nature; or (2) financial, but which we cannot readily assess via a common standard ratio."

The three qualitative factors are:

  • Business diversification, defined as the breadth of a bank's business activities.
  • Opacity and complexity, defined by the extent to which a bank's complexity heightens management challenges and the risk of strategic errors, as well as the degree to which financial statements are a reliable guide to its fundamentals.
  • Corporate behavior, defined as the extent to which a bank's strategy, management, and its corporate policies may reduce or increase its overall risk profile.

Knowing how Moody's or other ratings agencies analyze companies admittedly goes too far into the weeds for most investors. But given the impact that a bank's credit rating has on its cost of funds, which analogizes closely to a retail store's cost of goods sold, it's important information for current and prospective investors in bank stocks to know.

John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Moody's. The Motley Fool has a disclosure policy.