Credit ratings of Australian financial institutions have come under review in recent weeks as ratings agencies assess the damage being done to banks, building societies and credit unions by the shortage of funds in global capital markets and the sharp increase in the cost of funding.

Customers of a financial institution whose rating is downgraded may face higher borrowing costs, although such an outcome is by no means certain.

A rating assesses a company’s capacity to meet its obligations. It is a measure of creditworthiness and also financial stability (see box below).

One consequence of a rating change is that it affects the price at which companies can raise funds in the capital market. Banks and other financial institutions get a lot of the funds they use to provide home loans, credit cards and margin loans from institutional investors that use the capital markets.

A high rating, such as Aaa or Aa, means the company is very creditworthy and, as a consequence, can raise funds at competitive rates.

Consumers get the benefit as these competitive rates are passed on to them.

If a financial institution’s rating goes down its cost of funds will increase to reflect the higher risk the investor is taking when it buys its credit.

In theory, says Patrick Winsbury, the senior vice-president in the financial institutions group at Moody’s Investors Service, the higher cost of funds in the wholesale market brought on by a rating downgrade could lead to higher interest rates for customers.

Winsbury says this would not follow automatically and customers should not assume that it would.

“There are a lot of variables,” he says. “Financial institutions take [the] cost of funds into account when they set rates but they are also looking at their competitive position in the market.

“And a downgrade may not increase their cost of funds all that much. Financial markets are volatile and banks are very opportunistic when it comes to raising funds. They go into the market when they see a good deal and stay out when prices are high.

“There is not necessarily a direct link between wholesale and retail cost of funds. Lenders might seek to offset higher funding costs in other ways, such as by changing fee structures, or cross-selling other products,” he says.

Moody’s announced a few weeks ago that it had put Heritage Building Society under review for a possible ratings downgrade. At the same time it changed the ratings outlook for Newcastle Permanent Building Society from stable to negative.