Three considerations for including industry in risk rating
Credit analysts assign risk ratings with a focus on whether the lending institution will get its money back in full and on time. This forward view is the reason analysts will downgrade on expectations and upgrade on performance. Borrowers do not operate in a vacuum, however, and their environment is often impacted by things beyond their control. “Industry” sums up the factors of supply and demand, competition and substitution that will influence a borrower’s performance. The analyst evaluates industry as a factor when risk rating a loan since the overall environment can impact the borrower’s ability to repay the loan. Analysts can incorporate industry conditions and expectations in a few ways.
1. Consider the current industry condition. The current state of the industry provides a baseline for the analyst as they evaluate a specific loan. One of the most efficient ways to get a snapshot of performance is to summarize data of individual companies. Statistics such as the average debt service coverage ratio, change in sales period to period, and net profit margin can give a view of the industry’s overall health particularly if the analyst evaluates their trends. The analyst should ask a few questions before relying on this information, just as when working with any summary data. Is the underlying set of companies representative of the borrower? Are there enough data points to make conclusions meaningful? Are there outliers, and if so, why?
2. Consider where the industry is going. Risk ratings look to the future, although the past informs expectations. When it comes to including industry in risk rating, the analyst should not only think about the current performance but also about where the industry is going. Are there social trends that could impact the overall industry? For example, an analyst’s view on the future of newspaper companies would have been very different in 1980 than in 2000 and more so today. Is the industry overall generating excess returns that will encourage new entrants? Are regulatory changes expected that will impact the industry? The financial industry is a prime example of how changes in regulation can impact nearly every company within an industry. What other leading indicators should the analyst assess?
“The evaluation of each extension of credit should be based upon the fundamental characteristics affecting the collectibility of that particular credit. The problems broadly associated with some sectors or segments of an industry, such as certain commercial real estate markets, should not lead to overly pessimistic assessments of particular credits in the same industry that are not affected by the problems of the troubled sector(s)”
3. Consider how the specific borrower fits in. This is the final piece of the puzzle, and it goes both ways. If the borrower is not able to capitalize on a growing and profitable industry, making the prospects for the loan in question poor, then industry data alone cannot support a better risk rating. On the flip side, the analyst should be careful not to put downward pressure on the risk rating of an otherwise acceptable loan solely because of the industry. There should not be a “to be conservative” discount if reasonable and supportable projections that took into account the industry outlook are used to determine the risk rating. It is possible that every company within an industry would be considered substandard, and the analyst should analyze each to come to that conclusion individually and not simply assume that the industry will be the driving factor.
Download the free eBook Commercial Risk Ratings Considerations to learn best practices for building your risk rating system.