Why a Bank's Debt Rating Can Be a Competitive Advantage

By John MaxfieldFool.com

To get a leg up on the competition, banks need to have a high debt rating. Image credit: Photodisc/Thinkstock.

There are few competitive advantages as important as a bank's debt rating, which dictates the interest rate a bank must pay to borrow money as well as the amount of collateral it has to put up in order to do so.

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You can see this by comparing the credit ratings and borrowing costs at Wells Fargo and JPMorgan Chase to Bank of America and Citigroup . Standard & Poor's gives the former two debt ratings of A+ and A, respectively, compared to the latter two which both earn A- ratings.

Data source: Wells Fargo, US Bancorp, JPMorgan Chase, Goldman Sachs, BB&T, Bank of America, Citigroup, and Morgan Stanley.

When you look at this table it makes sense that Wells Fargo and JPMorgan Chase face lowering borrowing costs than Bank of America and Citigroup. For instance, while Wells Fargo pays a 1.45% rate on its long-term debt, Bank of America pays 2.22%. The difference between these figures adds up to a hefty chunk of change when you consider that Bank of America has $241 billion worth of long-term debt.

Low borrowing costs matter because they go to the root of a traditional bank's business model, which is to borrow money cheaply and reinvest it at a higher rate, pocketing the difference. Holding all else equal, a bank that can borrow money at a lower rate than competitors can price its loans lower as well. This empowers higher-rated banks like JPMorgan Chase and Wells Fargo to steal customers from lower-rated banks like Citigroup and Bank of America, who can't price their products as competitively without unduly sacrificing profitability.

Of course, there's more to a bank's funding costs than its debt rating. For instance, big banks are generally considered by the ratings agencies and institutional investors to be safer than smaller banks. This is because it's assumed that the government would step in to save the former in the event of trouble but not the latter, as regulators did during the financial crisis. This helps explain why JPMorgan Chase faces lower borrowing costs than US Bancorp despite the fact that US Bancorp has a higher debt rating.

The composition and riskiness of a bank's business lines also matters. While Goldman Sachs and Morgan Stanley sport the same A- rating from Standard & Poor's, the former pays a lower interest rate on long-term debt than the latter. This could be due to the unique dynamics of their debt arrangements, but it could also flow from the fact that Goldman Sachs has been much more capably managed over the last few years compared to Morgan Stanley.

These complications aside, bank investors would do themselves a favor to know how the ratings agencies view their bank holdings, as higher-rated banks are primed to produce better shareholder returns than their lower-rated rivals.

The article Why a Bank's Debt Rating Can Be a Competitive Advantage originally appeared on Fool.com.

John Maxfield has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Wells Fargo. The Motley Fool has the following options: short January 2016 $52 puts on Wells Fargo. The Motley Fool recommends Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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