Risk Rating Scorecards: 4 Key Considerations for Credit Unions
Some commercial lending organizations leverage a scorecard risk rating system that assigns values to different inputs and then weighs those factors to calculate a risk rating score.
The NCUA does not require credit unions to use a scorecard; however, they recognize the value that they may provide to credit unions. This value comes from the consistency that is afforded to the risk rating process. A secondary benefit of using a scorecard is that it provides a de facto underwriting checklist as the inputs to the scorecard should cover major areas of concern.
In the Commercial Risk Rating Considerations eBook, Abrigo Advisory Services Senior Consultant Alison Trapp outlines four key considerations for credit union management to use in evaluating their current risk rating policy.
1. Include qualitative and quantitative factors
In a recent Abrigo webinar Most Often Asked Risk Rating Questions, 83 percent of credit union and bank webinar respondents indicated their scorecards were at least half quantitative factors, and 42 percent said theirs were almost exclusively numbers driven. Quantitative inputs are a staple of credit analysis and contribute to meaningful and defensible decisions. However, limiting a risk rating matrix to only quantitative factors means certain critical elements may be excluded, making it more likely that the analyst will disagree with the outcome. If this happens often, analysts will discount the usefulness of the matrix and regulators will question the process.
It may seem counterintuitive that a matrix can include qualitative factors and still drive consistency. The key is to develop well-written choices for inputs. A discrete list is necessary to assign a value to each choice that will then be used in the rating calculation. For example, Management Experience as a factor can be broken down into “0-5 years’ industry experience”, “5-10 years’ experience” or “10+ years’ experience” that can then be numerically scored. Well-written choices ensure that analysts respond consistently to a question.
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2. Focus on drivers
Another benefit of using a scorecard is having a credit analysis process checklist to ensure that the analyst has considered all the relevant factors for a particular loan as dictated by the institution’s loan policy.
Why wouldn’t the matrix include every factor possible?
The reason is that some factors are more important than others, and a critical element can be marginalized even with weighting. For example, debt service coverage ratios (DSCR) are a primary input in nearly every type of loan. Consider how the impact of this one factor would be significantly diluted if there are 20 factors being used versus 10 factors. Extraneous factors may reduce the impact of what is truly critical.
3. Include industry considerations
The analyst evaluates industry as a factor when risk rating a loan since the overall environment can impact the member’s ability to repay the loan. The analyst can incorporate industry conditions and expectations in a few ways:
Consider the current industry condition – The current state of the industry provides a baseline for the analyst as they evaluate a specific loan.
Consider the industry outlook – When including industry in risk rating, the analyst should not only think about the current performance but also about where the industry is going.
4. Consider how the member fits in
How the member is performing relative to their industry is an important element, and it is a factor regardless of whether the industry is doing well or poorly as a whole. If the member is not able to capitalize on a growing and profitable industry and therefore the prospects for the loan in question are poor, then industry alone cannot support a better risk rating. Likewise, the analyst should be careful not to put downward pressure on the risk rating of an otherwise acceptable loan solely because of the industry.
Each credit union has the discretion to develop its own risk rating process. While scorecard development will not be one size fits all, these are some common elements lenders should contemplate.