Credit Unions: Determine Risk Ratings Scale Based on Portfolio Complexity
When a credit union establishes its risk rating system it has to decide whether it will require analysts to separately rate the borrower (capacity) and the loan (facility) or to assign one rating that considers both factors together. Said another way, it has to decide between a dual or single rating system. In the Commercial Risk Rating Considerations eBook, Abrigo Advisory Services Senior Consultant Alison Trapp outlines the benefit of both dual and single risk rating policies.
On one hand, a single rating system is simple. On the other, the dual rating system allows for more distinction in risk grades, which could be beneficial to the credit union. The answer to the question of which is better for a credit union is the same as many other questions in credit risk: it depends.
A dual rating system has two ratings: one that captures the overall creditworthiness of the borrower and one at the facility level. Differences between the two ratings are generally because of secondary support factors such as collateral, guarantees or letters of credit that would impact a single facility and not the borrower’s overall condition. In other words, the fact that a loan is secured by real estate may not reduce the risk of default, but it will mitigate the loss. Often loans that are unsecured or structured as cash flow loans will have a facility rating equal to the borrower rating because there is limited collateral or additional credit support to improve the facility rating.
The NCUA explains that while many credit unions have moved to a dual rating system over the last 15–20 years, the regulatory agencies do not require credit unions to do so. Smaller, less complex credit unions may find that a single rating system is sufficient. What is important is that the risk rating system captures consistently, accurately and in a timely manner “the ability and willingness of the obligor to repay and the support provided by structure and collateral.” Regardless of whether a credit union is using a single or dual rating system, the process should provide consistent ratings across product types for similar risk. Dual rating systems will make differences by loan type explicit by highlighting the impact of collateral on the rating. Single rating systems also need to account for differences in collateral, as highlighted by the NCUA.