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.

Winsbury says that apart from its reviews of the two building societies it has not changed an Australian bank's rating for some time.

However, the ratings agency changed its outlook for BankWest debt and deposit ratings to negative from stable at the end of April. This followed an identical ratings action in relation to BankWest's parent, the British bank, HBOS.

Moody's also issued a general commentary on the credit union sector, saying its credit outlook is negative due to pressures from the global financial crisis. Moody's expects to see merger activity in the industry as funding pressure forces institutions to look for economies of scale.

Winsbury says recent ratings actions are all a consequence of the problems in the global credit market.

"Pressures include increased funding costs, closure of securitisation markets and the potential for a slowing domestic economy [to affect] asset quality," he says.

Winsbury says customers should not fear that a ratings downgrade signals the imminent failure of the financial institution. "The banking industry regulator, the Australian Prudential Regulation Authority, and the Reserve Bank set tough standards for local financial institutions," he says. "It would be very rare to see a local bank with a rating below investment grade level."

Newcastle Permanent Building Society and HeritageBuilding Society have A2 deposit and credit ratings. Winsbury says this is a mid-range rating. BankWest has an Aa3 debt and deposit rating.

What the ratings mean

Moody's bank deposit ratings are opinions of a bank's ability to repay punctually its deposit obligations. Here are Moody's Long-Term Rating definitions:

Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit risk.

Aa High quality and subject to very low credit risk.

A Upper-medium grade and subject to low credit risk.

Baa Moderate credit risk. They are considered medium-grade and as such may possess certain speculative characteristics.

Ba Speculative elements and subject to substantial credit risk.

B Speculative and subject to high credit risk.

Caa Of poor standing and subject to very high credit risk.

Ca Highly speculative and likely in, or very near, default; some prospect of recovery of principal and interest.

C The lowest-rated class of bonds, typically in default, with little prospect for recovery of principal or interest.

Moody's adds numerical modifiers 1, 2 and 3 to each generic rating classification from Aa to Caa.

The modifier 1 indicates the obligation ranks in the higher end of its generic rating category; 2 indicates a mid-range ranking; and 3 indicates a ranking in the lower end of category.