what is asset quality review

Asset Quality Review

• 1.1 Asset Quality Review Thematic Areas
• 3 References

The asset quality review (AQR) was one of the components of the comprehensive assessment performed by the ECB prior to assuming full responsibility for supervision under the single supervisory mechanism in November 2014 [1] .

The aim was to enhance the transparency of bank exposures by reviewing the quality of banks’ assets, including the adequacy of asset and collateral valuation and related provisions.

Asset Quality Review Thematic Areas

The review focus on bank processes and polices, in particular those related to key accounting decisions. The specific thematic areas are:

• Classification of Financial Instruments : the classification and measurement of financial assets into Amortized Cost vs. Fair Value as per IAS 39 as well as treatment of equity positions, hedge accounting & derecognition;
• Application of the Fair Value Hierarchy : the classification of valuation inputs and corresponding exposures into the Levels of the IFRS 13 fair value hierarchy, where level 3 exposures are those for which valuation is based on unobservable model input parameters;
• Non-Performing Exposure (NPE) definitions: the definition of “Non-performing” relative to the EBA simplified approach for the AQR, including treatment of forborne assets;
• Forbearance and Restructuring : the restructuring policy, definition, identification and tracking of forborne assets, including the implication on provisioning;
• Provisioning processes and policies: the definition of “impaired”, appropriateness of impairment triggers, and policies and processes regarding the calculation of provisions;
• Collateral Valuation and disposal processes: the processes regarding collateral valuation across collateral types and conservativeness of written policies;
• Credit valuation adjustment calculation: the existence and coverage of the bank’s calculation of a credit valuation adjustment for derivatives;
• Groups of connected clients and country of the ultimate borrower: the processes in place to identify connected clients, and determine the ultimate borrower’s country of risk.
• Deconsolidation processes: the processes in place to decide when assets should be deconsolidated from the Balance Sheet
• Reserves for legal costs: the approach the bank takes to defining reserves for litigation etc.
• ↑ ECB, Asset Quality Review - Phase 2 Manual
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To put it simply, an Asset Quality Review (AQR) is an exercise conducted by the Reserve Bank of India (RBI) to assess the actual level of bad loans in the industry. A loan becomes bad or an NPA (Non-performing asset) if interest or principal is not paid in 90 days. Banks often engage in smart technical adjustments to show stressed loans as standard assets, through last-minute small payments. This eventually creates a bad loan bubble, resulting in a crisis. The RBI doesn't want such an eventuality. Hence, it initiated an AQR in 2015 unearthing huge backlog of NPAs and forcing banks to account for every single NPA. With the recent economic survey arguing in favour, a second AQR may be well on the way!

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Asset Specificity: Meaning and Varieties

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

What Is an Asset Quality Rating?

An asset quality rating refers to the assessment of credit risk associated with a particular asset, such as a bond or stock portfolio. The level of efficiency in which an investment manager controls and monitors credit risk heavily influences the rating bestowed.

Because asset quality is an important determinant of risk that profoundly impacts liquidity and costs, analysts go to great lengths to make sure they issue the most accurate evaluations possible. Indeed, their pronouncements can greatly affect the overall condition of a business, bank, or portfolio for years to come.

Key Takeaways

• Asset quality rating assesses the relative riskiness of assets held in a portfolio.
• The highest-quality assets are Treasuries and other highly-rated bonds.
• Banks evaluate the asset quality (given a score of 1 to 5) of their loan and securities portfolio to determine their financial stability.

Understanding Asset Quality Ratings

Analysts consider a multitude of factors when issuing asset quality ratings, including portfolio diversification, operational efficiency, and how existing regulatory frameworks may or may not limit credit risk.

A rating of “one” may signal that an asset possesses high quality with little credit risk. Such a rating would likely be assigned to ultra-secure U.S. government Treasury bills (T-Bills) . At the other end of the spectrum, a rating of “five” would likely be given to assets with significant credit deficits, such as high-risk corporate-issued junk bonds.

Asset Quality and Bank Financial Stability

Asset quality is also an important determinant of the overall financial condition of a bank. For banks, the primary factor affecting overall asset quality is the quality of their loan portfolio and their credit administration program.

Loans typically comprise a majority of a bank's assets and carry the greatest amount of risk to their capital. Securities may also comprise a large portion of the assets and also contain significant risks. Other items which can impact asset quality are other real estate, other assets, off-balance sheet items, and to a lesser extent, cash and due from accounts, real estate holdings, and fixed assets

The asset quality rating of a bank reflects its existing and potential credit risk associated with its loan and investment portfolios, other real estate owned, and other assets, as well as off-balance sheet transactions.

Asset Quality Ratings Definitions

The FDIC has established asset quality rating definitions that are applied to banks following a thorough evaluation of existing and potential risks and the mitigation of those risks. The definitions of each rating are as follows:

• A rating of 1 indicates strong asset quality and credit administration practices. Identified weaknesses are minor in nature and risk exposure is modest in relation to capital protection and management’s abilities. Asset quality in such institutions is of minimal supervisory concern.
• A rating of 2 indicates satisfactory asset quality and credit administration practices. The level and severity of classifications and other weaknesses warrant a limited level of supervisory attention. Risk exposure is commensurate with capital protection and management’s abilities.
• A rating of 3 is assigned when asset quality or credit administration practices are less than satisfactory. Trends may be stable or indicate deterioration in asset quality or an increase in risk exposure. The level and severity of classified assets, other weaknesses, and risks require an elevated level of supervisory concern. There is generally a need to improve credit administration and risk management practices.
• A rating of 4 is assigned to financial institutions with deficient asset quality or credit administration practices. The levels of risk and problem assets are significant, inadequately controlled, and subject the financial institution to potential losses that, if left unchecked, may threaten its viability.
• A rating of 5 represents critically deficient asset quality or credit administration practices that present an imminent threat to the institution's viability.

FDIC. " Asset Quality ." Accessed June 23, 2021.

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Asset quality review (aqr).

In November 2013, the European Central Bank (ECB) and the European Banking Authority (EBA) have agreed on the most significant parameters for the European Banking Union with the analysis of the leading banks balance sheets in the euro zone. The first step for the implementation of European banking project is the Asset Quality Review (AQR) that must be concluded by October 2014. The aim of the ECB is to evaluate the soundness and quality of financial balance sheets of 130 lenders. It is a European transparency initiative, whose main goal is to restore the confidence of international investors in the soundness of the EU financial system. The Asset Quality Review (AQR) includes a general risk assessment of the banks and a Stress Test (ST) in order to check the resilience in case of unfavorable market conditions.

Asset Quality Review (AQR). The ECB analyzes Balance for 130 Leading European Bank

In order to fund the real economy and allocate resources, European banks have to solve some domestic and managerial issues. Therefore, the AQR is a necessary step to link the financial sector to the real economy. For this reason, the leading banks of the EU members have started to revise their budgets and strengthen their balance sheets. The national authorities are equipped with suitable structures for monitoring, research and data transmission to the ECB.

The lending institutions submitted for review will be about 130 (85% of the EU banking system), including 15 Italian banks. According to the ECB, the AQR is a strategic step to stimulate the necessary corrective measures on the balance of European banks.

The AQR is organized on three levels of analysis as shown in Table 1: - overall risk assessment: quantitative and qualitative supervisory activities (liquidity, leverage, funding sources) currently carried out by national authorities; - asset Quality Review (AQR): a detailed review of loans, securities and financial instruments; - final Stress Test (ST): balance will be subjected to simulated deep recession for their ability to react.

Table 1: Balance analysis of European banks.

In this way illiquid assets will be reviewed, together with Contingent Convertible Bond (Coco Bond), sovereign debt and non-performing loans.

At the end of AQR, the ECB will give its rating on each national bank with the possibility to raise their capital if necessary. Governments will provide the necessary liquidity to prevent speculative attacks on their banks. Therefore, the ECB has provided for the establishment, by the European governments, of a network security with public financial resources to be used in case of necessity (public back stop).

BANCA D’ITALIA (2014) La recente analisi dei prestiti deteriorati condotta dalla Banca d’Italia: principali caratteristiche e risultati , Banca d’Italia (https://www.bancaditalia.it/media/approfondimenti/2013/analisi-prestiti-deteriorati/index.html)

EUROPEAN CENTRAL BANK (2014) Asset Quality Review Phase 2 Manual , ECB, March ( http://www.ecb.europa.eu/pub/pdf/other/assetqualityreviewphase2manual201403en.pdf?e8cc41ce0e4ee40222cbe148574e4af7 )

EUROPEAN CENTRAL BANK (2013) La BCE da inizio alla valutazione approfondita in vista dell’assunzione delle funzioni di vigilanza , Comunicato stampa BCE, 23 Ottobre ( https://www.ecb.europa.eu/press/pr/date/2013/html/pr131023.it.html )

HENRY J. e KOK C. (2013) A macro stress testing framework for assessing systemic risks in the banking sector , ECB Occasional paper series no 152 / October ( http://www.ecb.europa.eu/pub/pdf/scpops/ecbocp152.pdf )

OTTOLINI R. e UBALDI E. (2014) Liquidity Stress Test: da utili a necessari , FinRiskAlert.it ( https://www.finriskalert.it/liquidity-stress-test-da-utili-a-necessari-roberto-ottolini-enrico-ubaldi/ )

QUAGLIARIELLO M. (2013) Dall’analisi della qualità degli attivi allo stress test europeo , Contributi Bancaria n.9 ( http://www.bancaria.it/assets/PDF/2013-09.pdf )

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Asset quality reviews

Asset quality reviews (AQRs) are aimed at clarifying the situation of banks that are, or will be, subject to the ECB’s direct supervision. They help the ECB to ensure that the banks under its supervision are adequately capitalised.

The methodology applied in an AQR is set out in the dedicated AQR – Phase 2 manual .

Each AQR concludes with the disclosure of bank-level data. Once the review has been completed, the Joint Supervisory Teams, which include supervisors from the ECB and national competent authorities, follow up with the bank to address the qualitative and quantitative findings of the AQR. If an AQR is performed in response to a request from an EU country outside of ECB Banking Supervision, that country’s national supervisor will follow up on the AQR findings.

The supervisors address all identified risks as part of their day-to-day supervision of banks. In particular, the results of AQRs are factored into the ongoing assessment of banks’ risks, governance and capital as part of the Supervisory Review and Evaluation Process.

ECB concludes asset quality reviews of Crelan, Citadele banka, Goldman Sachs and Morgan Stanley

The results of AQRs performed before 2023 can be found on our comprehensive assessments page .

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