Bank Credit Rating Methodology

Transcription

1 Bank Credit Rating Methodology March 2016 Morningstar All Rights Reserved. Redistribution is prohibited without written permission. Morningstar s Credit Ratings & Research is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization ("NRSRO").

2 2 Overview of Methodology Morningstar's bank credit rating methodology is based on the same key components, or pillars, as its methodology for nonfinancial corporations: Business Risk, Solvency, Distance to Default, and a bank stress test, which is analogous to the Cash Flow Cushion for nonfinancial corporations. The methodology combines qualitative judgements with observable financial and market data to arrive at a model-derived credit score. However, the model score is only an input to the rating committee's final rating decision. The rating committee may accept or modify the model score to take into account trends in performance, anticipated company actions, or macroeconomic developments that may not be reflected in the model. This methodology currently applies only to U.S. bank holding companies, or BHCs, and to their banking subsidiaries. This is because of the lack of uniform data on foreign banks comparable to the Federal Reserve data on U.S. banks that we used to calibrate the credit model. Therefore, rating foreign banks against a scale developed on U.S. data would introduce unknown biases into the relative ranking of both U.S. and foreign banks. However, the methodology is applicable to foreign banks and Morningstar intends to expand coverage to non-u.s. banks as consistent information becomes available. The Morningstar BHC rating does not incorporate explicit government support. Instead, these ratings provide an ordinal ranking of the likelihood that a distressed BHC will be forced to execute its Dodd-Frank resolution plan ("living will") or be resolved by the FDIC through similar procedures. The fundamental rating is the stand-alone Corporate Credit Rating, or CCR, of the bank holding company. The Corporate Credit Rating is our estimate of the consolidated corporation's total economic capacity to meet all of its financial obligations, including counterparty obligations as they come due and in accordance with their terms. There are many bank holding companies, particularly at the regional level, whose only assets are equity in their banking subsidiary and with little or no debt at the holding company level. In these cases, the ratings at the BHC and bank level will be the same. However, obligor and security ratings of a BHC's bank subsidiaries may be notched up from the BHC's Corporate Credit Rating to reflect the structural subordination of BHC debt to subsidiary bank debt and the "bail-in" risk to BHC "plain vanilla" unsecured debt required by the Dodd-Frank legislation and Federal Reserve regulations. For convenience in exposition, the terms "bank" and "bank holding company" will be used interchangeably in the following description of our methodology, unless a specific distinction is made in the text.

3 3 Credit Methodology and Model Morningstar's BHC credit rating methodology and credit scoring model are conceptually similar to the Capital Adequacy, Asset Quality, Management, Earnings, Liquidity, and Sensitivity to Market Risk, or CAMELS, rating system used by U.S. bank regulators to rate credit risk of banks. The four key components, or pillars, of our bank rating methodology drive the Morningstar credit scoring model: 1) Bank Solvency Score (30% weighting) is a ranking based on a bank's capital adequacy, asset quality, earnings power, and liquidity profile. 2) Bank Stress Test Score (30% weighting) is an evaluation of a bank's potential to absorb loan losses while maintaining adequate capital levels. 3) Bank Business Risk Score (30% weighting) encompasses various measures of business risk, as well as Morningstar's proprietary Economic Moat and Uncertainty Ratings. 4) Distance to Default Score (10% weighting) is a quantitative model that rank-orders firms based on their likelihood of financial distress using market-based inputs. The Bank Solvency Score measures a bank's most recent performance in four key areas corresponding to CAMELS categories: capital adequacy, asset quality, earnings, and liquidity. The qualitative CAMELS factor of Management is a component of the Bank Business Risk Score. Sensitivity to Market Risk is estimated with the Bank Stress Test Score. The Distance to Default Score captures an additional risk, volatility of the BHC's own equity price. The weighted average of a bank's score on all four pillars determines the model-driven credit rating. I. Bank Solvency Score The Morningstar Bank Solvency Score is a quantitative assessment of a bank's health based on six accounting ratios that together measure capital adequacy, asset quality, earnings power, and liquidity (asset quality has two ratios and there is an additional ratio that combines capital and asset quality). Sample: Each quarter, approximately 600 bank holding companies with assets of $1 billion or more, representing the vast majority of assets in the U.S. banking system, are ranked on a relative percentile basis with respect to each of these metrics. These BHCs all report consistent, consolidated financial data to the Federal Reserve on form FR Y-9C and this data set is used to calculate the six metrics. Definitions: The metrics used to calculate the Bank Solvency Score, their assigned weightings, and the qualities they measure are as follows:

4 4 Capital (15%) Tangible Common Equity/Tangible Assets The Tangible Common Equity/Tangible Asset ratio is the most conservative leverage ratio for measuring a bank's capital position. Tangible Common Equity is highly correlated with regulatory Common Equity Tier 1 Capital but is a more stringent measure of a bank's capital cushion because it excludes the value of intangibles such as goodwill from the calculation of equity. The denominator is also conservative because it uses tangible assets rather than risk weighted assets. A high ratio is better because a bank will have more capital to counter losses with a higher ratio of equity/assets. Asset Quality (20%) Total Assets to Nonperforming Assets and Past-Due Loans Nonperforming assets, or NPAs, and past-due loans represent the troubled portion of a bank's loan book. In gauging "coverage," we consider a bank's ratio of total assets relative to nonperforming assets and past due loans. In this case the larger the multiple the better the credit quality. Asset Quality and Reserves Against Possible Loan Losses (15%) Allowance for Loan Losses/NPAs and Past-Due Loans A bank's allowance for loan losses represents a bank's second line of defense against loan losses. In general, the larger the allowance for loan losses in relation to nonperforming and past due loans, the better. Asset Quality and Capital (10%) Tangible Common Equity/Nonperforming Assets and Past-Due Loans Tangible common equity is a bank's third line of defense against credit losses. The more equity a bank holds in relation to nonperforming and past due assets, the better. Earnings Power (30%) Pretax Pre-provision Earnings/Average Assets Pretax, pre-provision earnings are a bank's first line of defense against credit losses. As such, it receives the highest weighting in the Bank Solvency Score. The higher a bank's core earnings power, the more losses it is capable of absorbing without affecting its allowance for loan losses or shareholders' equity balance. Liquidity (10%) Deposits/Liabilities Deposits are typically the lowest-cost and most stable source of funding for a bank. As a result, the higher the proportion of deposits to total liabilities, the better. The more deposits fund loans and other assets, the less the firm will have to borrow from capital markets and the lower its interest expenses will tend to be. However, deposits can also include "brokered-deposits," which are largescale CDs and other noncore types of deposits. These types of funding sources are difficult to

5 5 compare and are unevenly reported by banks. Computation: A BHC's relative ranking in each category is then weighted according to its overall importance, and a final Bank Solvency Score is assigned. The final Bank Solvency Score can range from a minimum of 0.0 to a maximum of 1.0. Example: A hypothetical Bank Solvency Score calculation, with historical trends, is shown below. SOLVENCY SCORE Sep-11 Sep-12 Sep-13 Sep-14 Sep-15 Metrics Assets / (NPA + Past-due Loans) 48.0 x 56.1 x 58.3 x 68.5 x 70.4 x Allowance / (NPA + Past-due Loans) 36% 43% 43% 50% 50% Tangible Common Equity / (NPA + Past-due Loans) 401% 462% 486% 598% 621% Tangible Common Equity / Tangible Assets 8.7% 8.5% 8.6% 9.0% 9.1% Deposits / Liabilities 91% 93% 93% 93% 93% Pre-tax Pre-provision Income / Avg Assets (annualised) 1.7% 1.8% 1.8% 1.8% 1.8% Percentiles Assets / (NPA + Past-due Loans) 20% 71% 77% 80% 82% 82% Allowance / (NPA + Past-due Loans) 15% 50% 62% 64% 69% 68% Tangible Common Equity / (NPA + Past-due Loans) 10% 75% 79% 81% 83% 83% Tangible Common Equity / Tangible Assets 15% 75% 75% 73% 75% 74% Deposits / Liabilities 10% 67% 75% 72% 72% 73% Pre-tax Pre-provision Income / Avg Assets (annualised) 30% 80% 84% 82% 81% 80% Solvency Score Note that in this hypothetical example, the institution scores very well with respect to earnings power better than roughly 80% of all banks tested. In addition, this bank has made very clear improvement in terms of its credit quality, especially with regards to its reserve coverage. Having only an average ratio of allowance/npa and past due loans of 50% in September 2011, it improved to beat 68% of the firms in the most recent quarter. Overall, the bank receives a weighted score of 0.77, meaning its Solvency Score is in the 77 th percentile of the banks in our sample. Trends in solvency are an important consideration in the final rating decision. Two banks could have the same solvency score but potentially different ratings if that score was the result of improvement at one bank and deterioration at the other. Historical tests on failed U.S. financial institutions have shown a strong relationship between the Morningstar Bank Solvency Score during the quarters leading up to failure, and subsequent financial distress. A test of the Bank Solvency Score used a sample of 90 banks that have failed from mid-2008 to mid-2011 compared with all surviving U.S. banks reporting on the same basis. The average Bank Solvency Score of the failed banks tested showed a consistent quarterly decline over the 12 consecutive quarters prior to failure, with significant differences occurring well before failure. The chart below illustrates the average Solvency Score of each group at various points leading up to failure, along with the failed banks scores' standard deviations.

6 Average Score 6 Solvency Score - US Banks 51% 55% 53% 54% 54% 54% 53% 53% 53% 53% 52% 53% 45% 42% Surviving Banks Failed Banks 41% 39% 36% 32% 28% 24% 20% 16% 13% 11% -12Q -11Q -10Q -9Q -8Q -7Q -6Q -5Q -4Q -3Q -2Q -1Q Quarters Before Failure II. Bank Stress Test Score The Morningstar Bank Stress Test Score evaluates a bank's capacity to handle additional losses in its loan and securities portfolios during a period of macroeconomic stress. This ability depends on the company's initial capital position, its potential to boost its equity base with earnings over the stress test projection period (two years), and on the level of its losses over the same period. Projected losses are deducted from initial capital and projected earnings are added. The Stress Test Score is based on a bank's expected capital position at the end of a two-year period of hypothetical elevated losses. As an absolute measure of capital, the Stress Test Score stands in contrast to the relative ranking of capital position when computing the Bank Solvency Score. The Morningstar Stress Test Score is calculated on a rolling basis each quarter. Thus, it continually measures a bank's ability to handle additional stress beyond any already recognized losses. We believe this reduces the need for analysts to forecast precise turning points in the credit cycle, given that the rolling test always incorporates an assumption of two years of elevated losses. Projecting Losses Expected loss rates in various loan and security categories are applied to a bank's most recent reported asset balances and the resulting total losses are subtracted from the bank's last reported capital position. For capital, we use tangible common equity.

7 7 The loss rates applied to various U.S. loan and security categories are listed below: Stress Test Loss Rates Loan Loss Rates Low Average High First Lien Mortgages 2.5% 3.5% 4.5% Junior Liens and HELOCs 4.5% 6.5% 9.5% Commercial and Industrial 4.0% 5.0% 7.0% Commercial Real Estate 8.0% 9.0% 11.0% Credit Cards 12.5% 14.0% 15.0% Other consumer 3.0% 6.0% 10.0% Other Loans 2.0% 3.0% 4.0% Securities Loss Rates Available for Sale & Held to Maturity 2.5% 5.00% 10.00% Trading Portfolio 2.5% 7.50% 12.50% Differences in underwriting standards and credit quality among banks are accounted for by adjusting loss rates based on analyst judgment. Analysts rate a bank's risk exposure for each type of loan as "Above Average," "Average," or "Below Average." For banks rated "Above Average" in risk exposure, expected losses will be calculated using the high end of the prescribed loss range. For banks rated "Average" in risk exposure to the loan category, the average loss rates are used. For banks rated "Below Average" in risk exposure, loss rates at the low end of the range are utilized. Risk exposure is judged based on underwriting standards and portfolio composition within each loan category. The Below Average, Average and Above Average loan loss rates are based on the lowest quartile, median, and highest quartile of the Severely Adverse loan loss rates of the 31 bank holding companies included in the 2015 Dodd Frank stress tests.

8 8 For some types of loans and securities, analysts have discretion to input an appropriate loss rate. For example, loans covered by FDIC loss-sharing agreements and other loan types that do not fit in a pre-defined category will be subject to analysts' judgment. Securities loss rates are applied to a bank's "at-risk" portfolios of trading, available-for-sale (AFS), and held-to-maturity (HTM securities, with U.S. government and agency securities excluded from the balances subjected to losses. All other securities are assumed to be vulnerable to loss, and subjected to standardized loss rates. The standardized securities loss rates are based on the International Monetary Fund's estimates of bank losses during the financial crisis. As with loan loss rates, the analyst takes into account the BHC's underwriting practices and portfolio composition in assigning the appropriate securities loss rate. Projecting earnings The Bank Stress Test Score adjusts Morningstar analysts' base case forecasts of future pre-tax, preprovision earnings and expenses for individual banks to reflect the reduced earnings to be expected during a recession. Estimates of pretax, pre-provision earnings (net interest income plus noninterest income minus operating expenses) are reduced by 5%, 25%, or 50% depending on how resilient the company's income is, as assessed by the analyst. These three haircut rates are in line with how banks have fared in past crises. For example, an institution with a very healthy mix of interest and fee income will usually see smaller falls in revenues during a crisis. In contrast, a bank that largely depends on its interest income will tend to experience a much more pronounced fall in its top line as more loans enter nonaccrual status during a crisis. Finally, forecasted changes in the allowance for loan losses are added or subtracted as necessary to the curtailed core earnings for the next two years. In quarters other than the final quarter of the fiscal year, analysts' annual forecasts are prorated over the appropriate time period. Calculating the Stress Test Score: Once losses are subtracted and forecasted earnings are added to a bank's current capital position on an after-tax basis, a final score is awarded based on the bank's expected capital position at the end of the two-year period. The Stress Test Score makes up 30% of the model credit score. The score is measured by both post-stress test Tangible Common Equity to current Risk-Weighted Assets (TCE/RWA) and post-stress test Tangible Common Equity to current Tangible Assets (TCE/TA). Both measures are used by U.S. and foreign regulators to measure capital adequacy and therefore we give them equal weight in the model. Each measure of capital cushion at the end of the stress period is compared to the appropriate scale of capital adequacy and "points" awarded as each ratio's percentage of the maximum capital ratio in the scale. This procedure limits the final score to values between zero and one both for comparability to the other pillar scores and because

9 9 Morningstar believes the stress test scores should be truncated at the high and low ends for reasons explained below. Points are awarded for the expected capital ratios based on the following scales: Tangible Common Equity to Risk-Weighted Asset Ratio 0.0 points: Less than 0.0% point (prorated): 0.0% 15.0% 1.0 point: Greater than 15.0% Tangible Common Equity to Tangible Asset Ratio 0.0 points: Less than 0.0% point (prorated): 0.0% 10.0% 1.0 point: Greater than 10.0% The two scores are then averaged to a final Stress Test Score ranging from 0.0 to 1.0 to make the scale comparable to the decile scores of the other three pillars for purposes of computing the total model score. For example, a bank with TCE to RWA of 10% and a TCE to TA ratio of 6% would get TCE/RWA and TCE/TA scores of 0.67 and 0.60 respectively. The final Stress Test Score would be the average of This would make the Stress Test Score, even though it is on a cardinal scale, comparable in magnitude to the percentile scores of other parameters of the model so that weighted average model score can be computed without further calculation. Note that the stress test scale is truncated at the bottom and the top. That is, banks with a capital deficiency (negative equity) get zero points no matter how large the estimated deficiency and banks with capital ratios in excess of the upper do not get additional points. Negative tangible equity for a bank indicates a "boundary condition" in that even a small negative balance indicates sufficient stress that markets and regulators would react before the negative balance grew larger. At the other end of the scale, post-stress capital ratios in excess of 15% exceed the levels markets and regulators expect from the best capitalized banks. A sample Bank Stress Test calculation for a U.S. bank is shown below:

10 10 STRESS TEST SCORE Tangible Common Equity 1,556,452 Risk-weighted Assets 10,760,025 Tangible Assets 17,400,745 Tangible Common Equity / Risk-weighted Assets 14.5% Post-stress TCE / Risk-weighted Assets 13.7% Post-stress TCE / Tangible Assets 8.5% TCE / RWA Score 4.6 TCE / TA Score 4.2 STRESS TEST RAW SCORE 0.88 STRESS TEST Underwriting Quality Last Quarter Reported - Date Sep-15 (1 = conservative, 2 = average, 3 = aggressive) Last Quarter Reported (1-4) 3 LOSS ESTIMATES Quality Rating PROJECTED LOSSES EXPOSURE (%TCE) MORE ADVERSE COMMERCIAL General Commercial (lines of credit, working capital loans, etc.) 1 3,723, , % Construction 2 825,438 74,289 53% Real Estate 2 2,410, , % Lease Finance 0 0% Other Commercial Loans 2 17, % 0 0% 0 0% Total Commercial Loans and Leases 6,976, , % CONSUMER Real Estate (mortgage) 1 298,339 7,458 19% Home Equity (Amortizing HE loans, HELOC, Jr. Liens) 2 462,525 30,064 30% Credit Cards/Unsecured Lines 2 100,650 14,091 6% Vehicle Loans 1 50,652 1,013 3% Other Consumer Loans 2 257,160 15,430 17% 0% 0% Total Consumer Loans and Leases 1,169,326 68,056 75% Other 0 Total Loans and Leases 8,146, , % Unearned discount (20,348) Allowance for loan losses (Reserves) (124,321) Net Loans and Leases 8,001, % SECURITIES Securities - Available for Sale 5,662, % Less: Federal Government and Agency AFS Securities 3,547, % At-Risk Securities - Available for Sale 1 2,114,805 52, % Securities - Held to Maturity 341,034 22% Less: Federal Government and Agency HTM Securities 251,761 16% At-Risk Securities - Held to Maturity 2 89,273 4,464 6% Securities - Trading 20,746 1% Less: Federal Government and Agency Trading Securities 0 0% At-Risk Securities - Trading 2 20,746 1,556 1% Total At-Risk Securities 2,224,824 58, % CUMULATIVE LOSS ESTIMATES 567, ,653 36% ANALYST PROJECTIONS Year 1 Year 2 Year 3 Net Interest Income 586, , ,355 1,929,781 Non-interest Income, Including Gains on Sale 297, , , ,211 Non-interest Expense 548, , ,418 1,702,498 Pre-tax, Pre-provision Income 334, , ,561 1,162,494 Post-Stress Allowance / Total 2-Year Credit Losses 50.0% (283,826) Stressed Pre-tax, Pre-provision Income Capital Generation 2 62, , , ,601 Less: Change in Allowance for Loan Losses (159,505) Less: Total Losses, More Adverse Scenario (567,653) Tax Rate - After-tax Change in Capital 35.0% (82,262)

11 11 In the "Loss Estimates" section, potential losses (a total of $568 million in this case) are calculated based on the "Underwriting Quality Rating" assigned by the analyst for each individual loan category and the range of potential losses given in the previous table. The "Analyst Projections" section pulls income forecasts from the analyst's discounted cash flow model. The "After-tax Change in Capital" ($82 million loss) --the sum of the analyst's trimmed pre-tax, preprovision income forecasts, the expected change in the allowance for loan losses, and the cumulative loss estimate-- is then added to the bank's current tangible common equity position ($1.56 billion). Post-stress ratios TCE/RWA of 13.7% and TCE/TA of 8.5% are calculated using current, pre-stress tangible asset and risk-weighted asset balances for purposes of conservatism, though both amounts would likely decline in a severe loss scenario. The final Stress Test Score (0.88) is an average of the TCE/RWA score and the TCE/TA Score [(13.7%/15% + 8.5%/10%)/2 = ( )/2 =.88]. III. Bank Business Risk Score The Business Risk Score for banks is similar to the scoring system used for nonbanks and incorporates six criteria: Size, Economic Moat Rating, Equity Uncertainty Rating, Geographic and Business Line Concentration, Management, Dependence on Capital Markets, and Country Risk Score. Points are awarded according to the following scale: Size (0-4 points): 10% of final Business Risk Score Historically larger banks have been less likely to fail than smaller banks, presumably because of benefits of size such as portfolio diversification and better access to capital markets. We assign a score based on asset size as follows: 0 points: Less than $1B in assets 1 point: $1B to $9.9B in assets 2 points: $10B to $49B in assets 3 points: $50B to $99 in assets 4 points: $100B to $999B in assets Economic Moat Rating (0-4 points): 20% of final Business Risk Score An essential part of our company analysis is the Economic Moat rating, which encapsulates our view of a company's competitive advantage and its ability to earn excess returns on capital compared to other companies in the same industry. 0 points: No Moat 2 points: Narrow Moat 4 points: Wide Moat

12 12 Uncertainty Rating (0-4 points): 10% of final Business Risk Score Morningstar Credit Ratings uses the Uncertainty Rating published by Morningstar Inc. equity analysts as a measure of the predictability of a bank's future revenue and income. The Uncertainty Rating is based on the magnitude of the difference in the estimated economic value of a firm in the equity analyst's upside and downside scenarios. It is a measure of the uncertainty of forecasts around a company's earnings (e.g., a regulated electric distribution utility would typically have a lower uncertainty rating than an undiversified primary commodity producer). We use the following scale for the Uncertainty Rating: 0: Extreme 1: Very High 2: High 3: Medium 4: Low As part of the credit rating committee's determination of the final assigned corporate credit rating, the committee may make adjustments to the uncertainty score or conduct an analysis regarding the sensitivity of the credit risk to potential changes in uncertainty. Geographic and Business Line Concentration (0-4 points): 10% of final Business Risk Score An important factor in the stability of a company's future revenue and profits is the diversification of both its product portfolio and its customer base. Other things equal, a company with a wide variety of products and a variety of end markets is less subject to economic or regulatory shocks than a more focused company. Banks are awarded one point for the presence of each of the following diversification factors, according to analyst judgment. +1: Noninterest income makes up a significant percentage of net revenue (e.g. deposit fees) +1: Loan book diversified across several loan categories +1: Loan book diversified geographically +1: Nonbanking income makes up a significant percentage of net revenue (e.g. payment processing, asset management, etc.) Management Grade (0-4 points): 15% of final Business Risk Score The Management Grade captures our view of a firm's management team as steward of bondholder capital, transparency, board independence, incentives and ownership, and investor friendliness. 0: Poor 1: Below Average 2: Average 3: Above Average 4: Excellent

13 13 Dependence on Capital Markets (0-4 points): 25% of final Business Risk Score Our analysts score each company on its need to access the capital markets over our five-year forecast horizon. Because capital markets are inherently unpredictable, a bank whose capital structure is weighted heavily to short term debt is more vulnerable to capital market disruptions than a bank with substantial funding from equity and long term debt. We approximate a bank's dependence on capital markets by its percentile ranking with respect to the following "stable funding" ratio:(equity + Deposits + Long Term Debt) / (Total Assets Cash) The ratio is similar in concept but less granular than the Basel III stable funding ratio and therefore easier to calculate with available data. The intent is to measure a bank's dependence on short term funding. The following scale is used as a guide to analyst judgement but the input to the model remains at the analyst's discretion if he or she believes information not captured by the ratio suggests a different result. 4 points: > 100% 3 points: 90% - 99% 2 points: 80% - 89% 1 point: 70% - 79% 0 points: < 70% Country Risk (0-4 points): 10% of final Business Risk Score We use a market-based indicator to reflect the creditworthiness of the firm's home country. This score is based on the quoted 5-year sovereign CDS spread. Points are assigned according to the following table: 4 points: less than 120 basis points 3 points: between 120 and 210 basis points 2 points: basis points 1 point: basis points 0 points: over 540 basis points This is not a distinguishing factor for U.S. banks. However, we have incorporated this into the model in anticipation of expanding the methodology and coverage to banks not domiciled in the U.S. Sovereign credit risk is a useful proxy for the general business conditions and financial market liquidity of a country and is a useful indicator of credit quality even in the absence of an assumption of government support.

14 14 Combining the six scores: The point totals are then multiplied by their respective weightings, and scaled to a final Business Risk Score ranging from 0.0 to 1.0. The final Business Risk Score makes up 30% of the final recommended credit score. IV. Bank Distance to Default Score The Distance to Default Score, or DTD, incorporates equity market prices into our analysis to measure the market equity "cushion" between the accounting value of the firm and the market value of the firm. Each quarter we examine 1) the ratio of market capitalization to total assets (MC/TA), and 2) the one year equity volatility for each of the approximately 300 BHCs with public equity. Step one is determining each BHC's percentile ranking for MC/TA and for equity volatility. Step two is multiplying each of these rankings to create an interaction term. The interaction term provides a way to incorporate the co-dependence between MC/TA and equity volatility and account for its impact on our predictor variable, DTD. The interaction term has the effect of dampening the signaling effect of one input variable when the other input variable does not provide the same magnitude or direction of signal. Additionally, the interaction term will increase the likelihood of the observed signal if both input variables are directionally consistent even if those signals are relatively weak. Step three is computing the equal (one third) weighted average of each of the three metrics and calculating the percentile ranking of each BHC with respect that average score. That percentile ranking is input directly into the credit rating model. Combining the Components of the Model Score To be consistent with Morningstar's credit rating scoring systems in other industries, where a lower score is better, every pillar's score, with the exception of the Distance to Default raw score, is subtracted from 1. The Distance to Default score is already calculated as "lower is better." The resulting four components are weighted (30% for Bank Solvency Score, Bank Stress Test Score, and Bank Business Risk Score, and 10% for Distance to Default) and summed to achieve a final combined score on a scale from 0 to 1. This combines percentile rankings for Solvency, Business Risk, and Distance to Default with an absolute score for the Stress Test on an equivalent 0 to 1 scale. The model numerical score is translated into a model recommended letter grade rating according to the following scale:

15 15 Model Recommended Rating Rating Maximum Score AA 20 AA- 25 A+ 30 A 35 A- 40 BBB+ 45 BBB 50 BBB- 55 BB+ 60 BB 65 The highest model recommended rating for a BHC is "AA," indicating "very strong ability to make timely interest and principal payments." In general, we expect financial institutions to score lower than nonfinancial companies, owing to their higher leverage and dependence on potentially unstable funding arrangements. The Credit Rating Committee can assign a final rating higher than AA to take into account qualitative factors that are not captured by the model. The lowest model recommended rating is BB. Credit quality below BB will depend on qualitative factors that cannot be analyzed by models. It is unlikely that any BHC would be able to fund its operations indefinitely with a rating below investment grade. The lower than investment grade ratings are included to follow credit quality deterioration to a level where resolution is likely. Assigning the Final Corporate Credit Rating to the Bank Holding Company We use our assessment of a BHC's scores with respect to business risk, solvency, the stress test and distance to default to arrive at a preliminary quantitative "model" credit rating for the BHC. Our process for assigning final credit ratings is as follows: 1) The analyst derives the preliminary model credit rating based on our proprietary credit rating methodology and credit rating model. The analyst reviews the model-driven rating, along with other company- and industry-specific factors, and determines a recommended rating. The analyst can recommend a higher or lower rating than the model-driven rating but must explain the reasons in the written presentation to the Credit Rating Committee, or CRC. 2) The credit analyst presents his or her recommended Corporate Credit Rating in writing to the CRC, which then meets to discuss the recommendation and vote on the final rating. 3) The credit committee has the discretion to accept or reject the analyst's recommendation and to assign a rating that may be higher or lower than either the model rating or the analyst's recommendation. The CRC minutes must contain an explanation of the CRC's decision and any

16 16 differences with the analyst and model recommended ratings. All initial credit ratings and changes to credit ratings are approved by a CRC. The analyst monitors company and industry developments to determine if they are material to the credit rating. If the credit analyst believes that the model-driven rating indicates that a change in the credit rating may be warranted, or if the analyst has other information that may warrant a change in the credit rating, the analyst will present the changes to a CRC. We place considerable emphasis on using both qualitative and quantitative analysis to arrive at our credit ratings. We apply weightings to each factor we consider, placing sizable weight on some of the proprietary metrics we have honed over time, including economic moat. We rate firms on an industry standard scale, as described in the summary table in the Appendix. See Morningstar Credit Research Definitions and Descriptions of Letter-Grade Ratings, Outlooks, Reviews, and Other Forms of Opinion published on Morningstar Select for details. Assigning Ratings to Bank Subsidiaries of BHCs and to Individual BHC and Bank Securities The BHC's Corporate Credit Rating is the credit rating of the BHC's "plain vanilla," senior unsecured debt, just as it is for Morningstar's nonfinancial corporate credit ratings. In cases where the only material asset of the BHC is equity in its banking subsidiary and the BHC has no material debt, then the obligor rating of the BHC and its principal banking subsidiary will be the same and the same as the senior unsecured rating of the banking subsidiary's debt. In cases where both the BHC and its banking subsidiary have material debt obligations and assets, it is necessary to distinguish between the BHC and the bank obligor ratings and therefore between the ratings of the debt issues of the BHC and its principal banking subsidiary. Morningstar's methodology assumes that resolution of large ($50 billion in assets) BHCs will follow the Single Point of Entry Process, or SPOE, described by the Federal Reserve as follows: In an SPOE resolution of a banking organization, only the top-tier bank holding company would enter a resolution proceeding. The losses that caused the banking organization to fail would be passed up from the subsidiaries that incurred the losses and would then be imposed on the equity holders and unsecured creditors of the holding company, which would have the effect of recapitalizing the subsidiaries of the banking organization. An SPOE resolution could avoid losses to the third-party creditors of the subsidiaries and could thereby allow the subsidiaries to continue normal operations, without entering resolution or taking actions (such as asset fire sales) that could pose a risk to the financial stability of the United States. The expectation that the holding company's equity holders and unsecured creditors would absorb the banking organization's losses in the event of its failure would also help to maintain the confidence of the operating subsidiaries' creditors and counterparties, reducing their incentive to engage in potentially destabilizing funding runs.

17 17 The inclusion of unsecured BHC debt in Total Loss Absorbing Capital, or TLAC, and the priority given to preserving confidence in banking subsidiaries require substantial differentiation between credit ratings at both the obligor and the issue level. The FDIC has also proposed to adopt the SPOE resolution policy. Furthermore, the FDIC's mandate to choose the resolution plan that is least costly to the bank insurance fund will severely disadvantage debt at the parent bank holding company level for all BHCs. Morningstar's guidelines for notching of ratings to reflect these differences in potential default and recovery risks are shown in the tables below. These guidelines are an application of Methodology for Ratings Parents, Subsidiaries, and Issues published on Morningstar Select. However, the same CRC that determines the BHC Corporate Credit Rating makes the final decision, and the CRC may use its discretion to deviate from the guidelines. Any deviation will be explained in the CRC minutes. Obligor and Issue Ranking Obligor Issue Notching from BHC Bank Holding Company BHC Senior Unsecured 0 BHC Subordinated -1 Subsidiary Bank +2 Bank Senior Unsecured +2 Bank Subordinate +1 Issue Ranking Issue Notching from BHC Priority of Payment Example Bank Senior Unsecured +2 1 AA- Bank Subordinate +1 2 A+ BHC Senior Unsecured 0 3 A BHC Subordinated -1 4 A- As noted above, where the only asset of a BHC is equity in its banking subsidiary, and the BHC has no material debt, then the obligor ratings of the BHC and its principal banking subsidiary will be the same. This will often be the case with smaller, regional BHCs.