How to Calculate Risk Ratings for Different Loan Types
While the specific criteria and related weightings of risk rating factors differ by institution, generally, the 5 C’s of Credit are used to drive these risk rating factors. The 5 C’s include: character, capacity, capital, conditions and collateral:
• Character: What is the character of the borrower? This is where qualitative or subjective elements of risk ratings may come in. Related factors include the institution’s relationship with the borrower, the quality of management, strength of references, payment history and credit scores.
• Capacity: What is the borrower’s capacity to repay the debt? Related factors include debt service coverage ratio, interest coverage ratio and credit scores.
• Capital: Is the borrower well capitalized? Related factors include debt-to-equity ratio, current ratio, quick ratio, debt-to-capital, return on equity and return on assets.
• Conditions: How are current economic conditions? Related quantitative factors that may play into risk ratings include data on local and regional economic conditions (eg.unemployment statistics), and industry data (eg. average net profit margins, sales growth and debt service ratios).
• Collateral: What is the value of the collateral that will serve as a secondary source of repayment for the loan if it defaults? A key quantitative factor that may go into risk ratings is the loan to value ratio.
Depending on the type of loan, the 5 C’s should be weighted differently when determining a risk rating. While character, capacity, and capital should always be strong, the weight you place on collateral and conditions can vary based on the loan type.
For example, for a CRE loan, the value of the property, or the collateral, is critical. On the other hand, for a C&I loan, it is necessary to place more emphasis on conditions. This includes looking at a peer group. It is also key to evaluate the volatility of the industry due to current market conditions when calculating a risk rating for a C&I loan. Examining industry volatility is less important for CRE loans.
The weight placed on these factors is important when evaluating the effectiveness of a risk rating system. If your institution has a broad system that is applied to multiple loan types, it is likely not as effective as a system that accounts for loan type.
Learn how to book loans faster while managing risk.
Abrigo recently polled more than 160 financial institutions and found that 16% of responding bankers do not have effective risk rating systems. If your institution’s risk rating system is not effective, you may benefit from making minor revisions, such as placing more weight on one of the 5 C’s based on the type of loan.
Put simply, the 5 C’s are a critical component to the risk rating process. Depending on the type of loan, certain factors may need to be weighted differently than others. For CRE loans, it is important to place more weight on collateral, while for C&I loans, placing more emphasis on conditions is critical. With a thorough understanding of how the 5 C’s contribute to a loan’s risk rating, bankers can more effectively determine individual loan risk, and uncover invaluable insight into the overall risk of their portfolio.
For more risk rating best practices, check out this whitepaper: Commercial Risk Rating Considerations.