The Number 1 Reason You Need to Check-in on Your Risk Ratings
In order to effectively manage credit risk, banks and credit unions need to be vigilant at all stages of the life of a loan, from origination to administration to portfolio risk management. The easiest way to do this is via a robust risk rating system. By assigning a single rating that represents a level of risk to every loan in the portfolio, banks and credit unions can easily monitor individual and portfolio level risk over time and across portfolio segments. Because of the universal benefit and applicability of risk ratings, it is important to revisit your institution’s risk rating methodology on a regular basis.
Risk ratings start playing a role in risk management and profitability before the loan is even booked. By applying risk ratings to proposed loans the institution can not only assess whether the risk of that loan is a fit for the institution, but also how that loan should be priced in order for it to be profitable given the level of risk.
Its also important to remember that a loan should undergo multiple risk ratings in its lifetime. By re-evaluating the risk rating on a loan, the institution can ensure that the risk rating is up to date and represents the current risk of the loan, not just the risk at booking. This process of updating risk ratings brings in the loan administration department, both to ensure that updated borrower information is collected in order to perform and update the risk rating for the loan, as well as to make sure that if the risk rating changes, the appropriate ticklers, covenants, and correspondence are updated based on the new rating.
Finally, risk ratings are crucial when performing stress tests and calculating the ALLL for the institution. Risk ratings also allow the bank or credit union to easily track changes in risk over time, and between different portfolio segments. However, in order for risk ratings to be useful for this type of analysis, it is necessary that the ratings be accurate and consistent across the portfolio. This means that “a 3 is a 3” no matter what type of loan bears that rating, or when that rating was applied, or which analyst performed the rating. This can be very difficult to do when multiple analysts handle risk ratings, or when ratings take into account subjective factors. Consistency is especially difficult to achieve across portfolio segments. A mortgage and a CRE loan are going to be rated using different factors, but the final ratings need to convey the same level of risk. In other words, a mortgage with a risk rating of 3 should bear exactly the same level of risk as a CRE loan with a risk rating of 3.
Risk ratings are truly the common language of credit. In order to maximize the use of risk ratings and effectively track risk in your institution’s portfolio, it is crucial to periodically re-examine your risk rating methodology.
Read this case study to learn how Chemung Canal Trust Company uses Sageworks Risk Rating as part of their credit team to systematize risk ratings and ensure consistency across the growing bank.