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Key components of credit risk rating systems

by: Sageworks

One of the most popular tools to monitor credit risk is a standardized risk rating system. A credit risk rating system provides banks and credit unions the opportunity to grade transactions in their commercial loan portfolio by level of risk. CEIS Review, a New York-based bank consulting firm, recently published an article on these systems in their newsletter, The CEIS Quarterly. The article cites a lack of specific requirements and standard models for credit risk rating systems. The only requirement from regulators is assigning transactions, when appropriate, to four criticized categories: special mention, substandard, doubtful and loss.

Because there is no standard model, each institution is allowed to customize a risk rating system to fit its own needs. However, each institution should pay special attention to the level of detail included in its model. According to CEIS, the “number of grade levels will primarily depend on the breadth of the spectrum of risk embedded in the portfolio, and where within that range it lies both in dollar terms and in terms of number of transactions and/or clients.” Finding the right balance between having insightful information and avoiding unnecessary complexities is key.

In 2001, the OCC published the Comptroller’s Handbook on Rating Credit Risk, which highlighted the expectations of credit risk rating systems:

1. The system should be integrated into the bank’s overall portfolio risk management.
2. The board of directors should approve the credit risk rating system.
3. All credit exposures should be rated.
4. The risk rating system should assign an adequate number of ratings.
5. Risk ratings must be accurate and timely.
6. The criteria for assigning each rating should be clear and precisely defined using objective and subjective factors.
7. Ratings should reflect the risks posed by both the borrower’s expected performance and the transaction’s structure.
8. The risk rating system should be dynamic.
9. The risk rating process should be independently validated.
10. Banks should determine through backtesting whether the assumptions are valid.
11. The rating assigned to a credit should be well supported and documented in the credit file.

 
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With these expectations in mind, CEIS highlighted a nine-grade system often used by banks:

• Grades one and two (the top grades) are generally reserved for “cash collateralized transactions, claims on the federal government, transactions secured by marketable financial instruments, federally guaranteed portions of SBA loans and loans to investment grade entities.”
• Grades three through five (pass credits) are usually split into low, medium and high risk transactions. In most cases, the majority of the bank’s portfolio will be in this category.
• Grades six through nine (problem credits) incorporate the four criticized categories: special mention, substandard, doubtful and loss.

Further enhancements to the rating system can be made, including the use of a watch list for potentially problematic credits and/or the use of split ratings when some portions of a loan are secured/guaranteed but the rest is not. According to CEIS, some banks even differentiate between borrower risk and transaction risk by rating them separately. Others use a rating matrix where different risk criteria are scored separately, applied a certain weight and then averaged to obtain the score. Regardless of the system used, consistency is critical.

The main purpose of a credit risk rating system is to “measure and manage the risk contained in individual credit transactions.” This allows institutions to generate a risk profile of the entire portfolio, which can then be tracked and measured over time to analyze changes in risk. Banks also use the rating system to calculate reserves, as the ability to segment their portfolio based upon risk is critical to making ALLL calculations.

Another benefit is the ability to standardize pricing. A weighted average price can be calculated for each grade, and then used as a reference point when pricing future transactions. This helps ensure consistency and adequate returns on the risk being incurred.

For more credit risk rating system best practices, access the full article by CEIS

 
About the Author

Sageworks

Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest real-time database of private-company financial information in the United States. The company was acquired in 2018 and is now part of Abrigo.

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