Asset quality refers to the overall risk attached to the various assets held by an individual or institution. This term is most commonly used by banks determine how many of their assets are at financial risk and how much allowance for potential losses they must make. The most common assets requiring a strict determination of asset quality are loans, which can be non-performing assets if borrowers default on repayment obligations. Risk managers often assess the quality of assets by assigning a numerical ranking to each asset depending upon how much risk is involved.
Much of the modern business world depends on credit arrangements and loans being offered from one institution to another. Unfortunately, there is always a risk that borrowers will not pay back either the initial amount of the loan or the interest payments required by the lender. Banks, which offer various types of loans, must make sure that they are protected against defaults that can cause their overall operations to suffer, in turn causing damage to local and possibly national economies. A solid assessment of asset quality is crucial to the overall success as a financial institution.
The general idea behind asset quality ratings is to assess the individual risk associated with each specific asset. Although there may be different techniques used by risk managers, the most basic way to rate assets is on a scale of one to five. A ranking of one would indicate that the asset, like a government bond, has little to no risk attached to it, while a ranking of five indicates that there is a distinct possibility that the asset in question, like a so-called junk bond from a corporation with a low credit rating, will return nothing to the institution holding it.
While the companies that borrow from banks and other lenders are most commonly associated with asset risk, all types of investments should be assessed in terms of asset quality. For example, investing in stock is risky if companies offering stock are suffering. Investing in real estate can be problematic if the real estate market has a rough patch. There is essentially no such thing as a risk-free investment.
Once the asset quality of a particular investment is determined, banks and other institutions can go about assessing the risk levels of their entire portfolios. The best way to attack a portfolio is to balance out the high-risk investments with safer ones that are almost sure to bring something back. In addition, a bank should always make sure that it can cover financially for all of its risky assets should a worst-case scenario occur.