Broadly speaking, the credit quality of a bank is its financial solvency as manifested in its ability to continue its operations as a going concern. This involves its ability to meet its obligations towards all its stakeholders, including the ability to meet regulatory requirements related to its capital.

From another perspective, the credit quality of a bank is reflected in the extent to which it is able to lower default risk and impairment losses as to the loans and similar credit facilities it extends or has extended to its customers. The higher the ability to do so, the high the credit quality of the bank is.

The most popular measures of credit quality of a bank relate to the quality of its loan portfolio, including non-performing loans ratio (NPL ratio), coverage ratio and cost of risk.

The NPL ratio is the ratio of non-performing loans (NPLs) to total credit (total loans) extended by the bank, expressed as a percentage. Non-performing loans (numerator of the ratio) represent unpaid or delinquent balances (for periods exceeding 90 days) and balances that are current but whose payments carry a high probability of default (PoD).

The coverage ratio constitutes the ratio of on-balance (OnB) sheet provisions for potential credit impairment losses to the total amount of non-performing loans, expressed as a percentage. The ratio gives an indicator as to the size of non-performing loans that is covered by provisions.

The cost of risk is the ratio of provisions recognized by a bank over a given period (usually, annualized) to the average size of the loan portfolio during the respective period, normally expressed in terms of basis points. This measure of credit quality gives an indicator as to expected losses in the bank’s loan portfolio.

Such measures (NPL ratio, coverage ratio and cost of risk) must be considered and analyzed together, as one cannot be reliable in isolation. For example, a bank with a not too good an NPL ratio, a low cost of risk and a high coverage ratio can be still perceived of a good credit quality standing.