4 Reasons to Review Your Bank’s Risk Rating System
Risk rating practices for the loan portfolio can draw scrutiny from regulators, to be sure. One of every six financial institutions responding to the 2015 Abrigo Bank & Credit Union Examination Survey said that examiners criticized or required action related to their risk ratings practices.
But avoiding regulators’ inquisition isn’t the only reason that banks and credit unions should review their risk rating systems. Here are four more reasons discussed during an Abrigo webinar.
1. The risk rating determines the credit approval process and pricing for the loan
During the risk rating process, the lender is determining the borrower’s ability to repay the loan and assessing the potential volatility of future loan payments.
Typically the five Cs of credit are used to determine a risk rating, and here are common measurements used:
Conditions: Global Cash Flow
Capacity: Global Debt Service
Capital: Global Debt to Equity
Character: Strength of Financial Statements
Collateral: Loan to Value or Additional Assets
As a part of this process, lenders should also look at the future projections of the borrower’s business, not just past performance. Underwriting agreements, financial projections and the health of the borrower’s industry are all very important as they will be leading indicators of potential volatility in loan payments.
So why is an accurate risk rating so important during credit approval? Because incorrect ratings could lead to undue risk in the portfolio. If the institution does not have a reliable and consistent way of giving a risk rating to a business, it is very difficult to have an accurate read on the borrower’s ability to repay the loan.
2. The risk rating prepares relationship managers to determine how often to review the loan
The initial risk rating can set the stage for how lenders handle the loan during the repayment process. Once a borrower has an accurate risk rating, the relationship managers can decide how to review the loan and how often they want to review it.
For example, if a borrower has been given a higher risk rating, the relationship manager will want to collect financial statements more regularly to make sure the borrower is not at risk of default. They will also want to verify that appraisals are being completed regularly to assess the ability of repayment with collateral. Finally, a risk rating can help the lender determine if they will reprice or re-structure the loan when it comes time for renewal.
3. Risk rating sets the foundation for the risk management of the entire loan portfolio
While it is always important to manage risk on a loan-by-loan basis, it is also extremely important to manage risk for the entire portfolio. And to effectively manage risk for the entire portfolio, it is crucial to have accurate risk ratings for every single loan. If a lender is assessing the risk of a portfolio of loans and the individual loan risk information is inaccurate, the overall portfolio information might also be inaccurate.
Increase objectivity with detailed, standardized documentation.
With a risk rating system in place that allows for accurate and consistent ratings, portfolio managers can perform a variety of risk management exercises such as setting the reserve, stress testing, capital planning, and strategic planning. These analyses are instrumental in ensuring the institution’s safety, soundness and optimal financial management.
4. The risk rating gives the management team, board and auditors a view of trends in risk levels.
From a risk management perspective, transparency throughout the organization can be crucial. By having a reliable risk management system that is consistently used by analysts, it allows the entire organization to see an accurate picture of the loan portfolio at a given time. All of this allows the management team to make decisions that minimize risk and improve profits through efficiency.
As noted earlier, 1 out of every 6 organizations was criticized or forced to take action related to risk rating practices. Having a risk rating system can give transparency to regulators and to auditors who can see historical information and consistency of lending practices.
Watch Abrigo’s on-demand webinar Real Price of Risk, Loan Pricing, and Risk Rating to learn best practices for building your risk rating system.